October 8, 1999
Mr. Jonathan G. Katz, Secretary
SECURITIES AND EXCHANGE COMMISSION
450 Fifth Street, N.W.
Washington, D.C. 20549
"Aircraft Carrier" Release No. 33-7606A;
File No. S7-30-98
Dear Commissioners:
We submit this letter in response to the request of the United States Securities and Exchange Commission for comments on the Regulation of Securities Offerings, Release No. 33-7606 (November 3, 1998) as amended by Release No. 33-7606A (November 13, 1998), 63 Fed. Reg. 67,174 (December 4, 1998). This release is commonly known as the "Aircraft Carrier" and is hereinafter referred to as the "Release."
We are representatives of seven leading Silicon Valley law firms and a member of the faculty of Stanford Law School. The views as reflected in this letter constitute a consensus of our individual perspectives. They do not reflect the official positions of the law firms or other organizations with which we are affiliated, or the clients of any of our law firms. Because this is a consensus document, we individually reserve the right to express views that may not be fully reflected in this letter.
We are affiliated with law firms that, in the aggregate, have been involved with well over half the capital formation activity in Silicon Valley. At various times, each of our law firms has represented high-technology issuers, the venture capital firms that provide the risk capital to those enterprises, founders and employees of those high-technology firms, and the underwriters that take high-technology firms public. We are individually familiar with the issues that arise in these transactions, and we believe that we have a broad insight into the operation of the capital formation process in the high-technology industry, particularly as it is practiced in Silicon Valley. We also believe that our experience reflects a balance of the interests of the major constituencies involved in many capital market transactions that would be affected by the Release.
Silicon Valley's significance to the growth of the United States' high-technology sector and the nation's economic growth generally is well understood. High-technology firms often do not have the luxury of financing their current operations or growth out of captive cash flow, as is often the case with older, more established firms. High-technology firms in Silicon Valley and elsewhere therefore commonly require infusions of new capital from the public and private capital markets in order to invest in the latest technology, as well as to develop new market opportunities. High-technology firms are thus particularly sensitive to the costs of capital formation and to the efficient operation of the capital formation process. High-technology firms are also subject to market conditions that may cause IPO windows to open or shut suddenly for reasons that are not within the firms' control. It may, therefore, be necessary to adjust a firm's capitalization plans rapidly so as to select between public and private markets, again for reasons that may not be within the firm's control. The high-technology sector is thus particularly sensitive to many of the changes in the capital formation process contemplated by the Release.
We understand and appreciate many of the considerations that led the Commission to issue the Release. The Commission is to be commended for undertaking such an extensive and thoughtful review of the capital formation process. The Release contains several useful insights and constructive proposals for reform, which we support, and which we urge be adopted as quickly as possible. On balance, however, the Release threatens to create far more problems than it would solve. If adopted in its current form, the Release would raise the cost of capital formation without yielding offsetting benefits in terms of investor protection, or any other benefit discernable to us. If forced to choose between a decision to adopt the Release in its entirety or to reject it, we would without hesitation urge that the Release be rejected. We are not alone in these views. The submission of the American Bar Association and the significant majority of the commentary of which we are aware concur with this perspective.
Rather than undertake to comment in detail on each proposal contained in the Release, we limit our comments to six subject matters that are, we believe, of particularly significance to high-technology firms in general and to the Silicon Valley economy in particular. Our failure to address the large majority of the proposals included in the Release should not be construed as support for those proposals. As described in greater detail below:
(1) We strongly support the adoption of proposed Rule 159 to clarify Commission policy regarding shareholder-voting agreements entered into in connection with Rule 145(a) transactions. We also provide suggestions for clarifying the proposed rule by eliminating certain ambiguities that may be raised in the current draft.
(2) We strongly support the Commission's efforts to provide greater certainty regarding the integration of public and private offerings through proposed Rule 152. Again, we provide suggestions for clarifications that will be valuable in situations that frequently arise in high-technology transactions.
(3) We strongly oppose the Release's proposed limitations on the use of short-form resale registration statements. Short-form resale registration statements have been common for decades in high technology financing. Short-form resale registration statements serve a legitimate and well-understood function in providing liquidity to technology firms and investors alike, and help reduce the cost of capital without any discernable sacrifice to investor protection. The proposals contained in the Release would unnecessarily and significantly raise capital costs for honest issuers without benefiting investors.
(4) We strongly oppose the Commission's proposals regarding the use of web pages and other communications during the offering period. Contrary to the Commission's own expressed intent to facilitate the flow of information to investors, we believe that the additional litigation exposure and uncertainty generated by the proposals will cause issuers to reduce information flow to the public, lead to less information being available over the internet, increase transactions costs, and generate unnecessary litigation risk.
(5) We strongly oppose the Commission's proposals relating to Exchange Act disclosures. Those proposals are highly impractical, particularly for smaller publicly traded issuers who do not have the large legal staffs of Fortune 100 firms. These proposals would also generate unnecessary litigation risk without a concomitant increase in the quality of the disclosure or investor protection. In addition, the proposals are inconsistent with prudent principles of delegation that are well accepted in corporate law and that are reflected in the statutory design of the federal securities laws themselves.
(6) We also include comments on the "testing the waters" proposal contained in Rel. No. 33-7607, proposed Regulation M-A. We generally support this proposal and again offer suggestions that will, we hope, help improve the implementation of the proposed regulation.
I. Voting Agreements Under Proposed Rule 159
We strongly support the adoption of proposed Rule 159. That proposed rule clarifies the policies of the Commission and helps eliminate potential legal uncertainties regarding shareholder-voting agreements (so-called voting "lock-ups") entered into in connection with Rule 145(a) transactions. In light of the potentially inconsistent views of securities practitioners on certain issues presented by these agreements, and in light of the frequency with which these issues continue to arise, we urge that the Commission adopt Rule 159 at the earliest possible juncture, without regard to its stance on the other proposals set forth in the Release. There are, however, several respects in which the rule might be enhanced.
A. The Rule Should Address Voting Agreements for all Purposes.
As currently worded, the proposed rule appears to focus exclusively on a single, relatively narrow issue. It merely confirms that securities subject to a voting agreement can be included in a subsequently filed registration statement relating to the transaction for which the voting agreement was originally obtained. We believe that, for clarity and completeness, the rule should address more broadly the legal effect of voting agreements for all purposes under both Section 5 of the Securities Act and Section 14 of the Exchange Act.
As proposed, the rule does not expressly address the possibility that the offer and sale suggested by the execution of a voting agreement might be deemed to constitute impermissible "gun jumping." The proposed rule also fails to address the possibility that, at least in the context of an aborted transaction in which no registration statement is ever declared effective, the offer and sale that might be suggested by the execution of a voting agreement might be deemed to constitute a violation of Section 5 of the Securities Act by virtue of the lack of availability of an applicable exemption. Moreover, the proposed rule does not address the possibility that a party obtaining voting agreements might, under some circumstances, arguably be deemed to have violated Section 14 of the Exchange Act and the related proxy rules.
We believe that it is important to add an express statement to avoid future uncertainty regarding the status of voting agreements. We suggest the following language be added to the rule following the enumerated paragraphs:
"The execution or performance of a voting agreement consistent with (a), (b) and (c) above shall not constitute, or in conjunction with a registration under the Act give rise to, a violation of Section 5 of the Act."
Further, a rule corresponding in its elements and coverage to the final language of paragraphs (a), (b) and (c) of Rule 159 should be adopted as a part of Regulation 14A to the effect that the execution or performance of a voting agreement is not a "solicitation" in violation of Section 14 of the Exchange Act or Regulation 14A, even though not preceded by a proxy statement.
B. Paragraph (a) of the Rule Should Provide Enhanced Definitions of the Categories of Persons Who May Execute Voting Agreements.
Paragraph (a) of the proposed rule could be usefully enhanced with definitions of its existing categories of persons who may execute voting agreements, or through cross-references to definitions set forth in other rules. For example, the Securities Act rules do not contain a definition of "executive officer." Rule 3b-7 under the Exchange Act does however provide such a definition. A cross-reference to Rule 3b-7 would be useful. Similarly, a cross-reference to a definition of affiliate, such as that articulated in Rule 501, would be constructive.
The term "founder(s)" is not, to our knowledge, defined in the rules and requires a definition to further the utility of the rule as a safe harbor. We offer the following definition: A founder is "a person who became a securityholder of the company prior to the receipt by the company of $1,000,000, in the aggregate, in cash as the purchase price for its equity securities." The proposal avoids the ambiguity inherent in any attempt to define a "founder" by reference to formation date, organization date, or first funding date, or specific services performed. Instead, the proposal provides a precise and easily applied definition that clearly focuses on early participants in the venture.
In addition, the term "family members" is ambiguous and clarification in the context of a safe harbor is appropriate. Common issues include whether "family" connotes parents, siblings, or more distant relatives, and whether family is limited to people occupying the same residence. We note that the Commission has adopted a definition of "immediate family" in Rule 16a-1(e), which could be applied in this context. Additionally, we believe it is appropriate to place the reference to family members as the last clause in paragraph (a) (i.e., after the reference to 5% shareholders, because 5% shareholders may on occasion be individuals), and to modify the reference to read, "and family members of any of the foregoing." This should also help clarify the ambiguity in the proposed language as to whether "and their family members" refers only to founders or to all previously enumerated categories of natural persons.
Regarding the phrase "holders of 5% or more of the voting equity securities," we believe it would be appropriate to assume conversion of convertible equity securities for purposes of this calculation. A hybrid capital structure consisting of both common stock and convertible preferred stock is common among private companies that are being acquired. In a number of instances, preferred stock is nonvoting, but is convertible into common stock with full voting rights. In other instances, the preferred stock converts other than on a one-to-one basis such that the voting power and equity interest of the preferred stock is de facto greater than the simple number of shares of preferred stock held by the investor. In these cases, a focus on the current number of securities, rather than the number assuming conversion, inaccurately reflects the voting power and equity interest of those securities. Accordingly, we suggest that the phrase "assuming conversion of convertible equity securities" be added following the 5% shareholder clause in paragraph (a).
Additionally, the 5% calculation should reflect the aggregation of entities under common control, and should not focus on a single entity's holdings. Many venture capital firms will invest in a company through a series of partnerships or limited liability companies that individually may not hold 5% of the Company's outstanding equity securities, but in the aggregate hold in excess of 5% of the Company's outstanding equity securities.
Paragraph (a) should also be expanded with new categories, so that entities commonly used for estate planning purposes, such as living trusts, family partnerships, and limited liability companies, would also fall within the scope of the rule if they are under the control of, or formed for the benefit of, an individual or family member in one of the identified categories. The rule should also clearly indicate that entities represented on the board of directors who hold less than 5% of the outstanding shares, such as venture capital partnerships whose designees serve as directors, may also execute voting agreements.
C. Clause (c)(2) Creates Ambiguity and Should be Eliminated.
Notwithstanding the explanation set forth in the Release, we fail to see the public policy rationale for the element contained in clause (c)(2) of the proposed rule. Because we believe that the inclusion of clause (c)(2) could lead to anomalous results, we suggest that it be eliminated.
As we read the proposed rule, Rule 159's safe harbor would not be available unless votes will be solicited from shareholders that have not entered into voting agreements and such shareholders are "ineligible to purchase under an exemption from registration." In many circumstances, a merger transaction could be an exempt transaction but is in fact registered. We are concerned about possible interpretations of the rule, as drafted, suggesting that the use of a voting agreement could constitute "gun-jumping" in a situation where the transaction may have been exempt, but in fact was registered, because the issuer could not conclude that all shareholders being solicited who have not executed voting agreements are ineligible purchasers under Section 4(2), Section 4(6) or Rule 506. Clause (c)(2) may thus be in conflict with the Commission's general public policy to encourage registration, particularly in circumstances where the question of whether registration is required is a close issue. Indeed, it would be anomalous if clause (c)(2) were interpreted to limit application of the rule only to those transactions where registration was clearly required; for example, where the target company is a public company, and to preclude its availability in situations where registration may not be so clearly required.
In our practice, we face many circumstances where it is difficult to determine whether a transaction is exempt from registration pursuant to Section 4(2), Section 4(6) or Rule 506. This can occur for a number of reasons, including a lack of understanding as to the financial circumstances or sophistication of the shareholders of the target company, or a lack of knowledge at the commencement of the transaction as to whether shareholders will prepare and sign the questionnaires and other documents commonly used to establish the availability of Rule 506. For these reasons, in situations where a transaction might arguably qualify for exemption under Section 4(2), Section 4(6) or Rule 506, counsel or the issuer may decide at the commencement of the transaction to register the securities to avoid the risk of a Section 5 violation. In that context, the availability of Rule 159, if (c)(2) is included, may be uncertain because an issuer cannot know whether one of the exemptions will be available without full knowledge of the shareholders' background and without their cooperation. The availability of Rule 159 should not turn on whether an exemption afforded by Section 4(2), Section 4(6) or Rule 506 could be utilized in optimal circumstances.
For these reasons, clause (c)(2) should be deleted from the final rule.
II. Integration of Public and Private Offerings.
The Commission's proposals to provide greater certainty regarding the integration of public and private offerings under the securities laws are generally beneficial. High-technology firms may require substantial amounts of capital to fund the development of their technologies and anticipated future growth. The period from founding of a new business to its initial public offering has shortened dramatically in the last few years. As a result, Silicon Valley companies may close private placements within months or even weeks before filing a registration statement for their initial public offering. High-technology companies, because of their frequent financings and need for capital, are also placed in a difficult financial position if they are forced to delay or abandon an offering (whether private or public) due to changes in market conditions. The lack of clarity under the Commission's existing five-factor integration test and Rule 152 has often made it difficult to advise issuers on the timing and type of securities they may offer after an abandoned or incomplete private or public offering. While we generally approve of the Commission's proposals in this area, we offer the following observations on proposed Rule 152 as applied to three circumstances discussed in the Release.
A. Completed Private Offerings Followed by a Public Offering.
As proposed under the Release, Rule 152 would provide greater certainty and flexibility in completing private offerings prior to an initial public offering. Provided that the offering is "completed," Section 5 concerns regarding a private offering completed within six months prior to the filing of the registration statement will be eliminated. In addition, the definition of "private offering" in the Release would include, for the first time, private offerings under Rule 506 of Regulation D. While we urge the Commission to include private offerings under Rule 505 of Regulation D, our experience has been that most later stage financings rely on Rule 506 due to the size of the transaction and the advantage of the blue sky preemption for such offerings.
Under the Release, an "offering" is complete when all the purchasers have paid the full purchase price for the securities in the private offering. Even if the purchase price had not been paid in full by the purchasers in a private offering, under Rule 152 an offering can be "complete" if the following conditions are met:
(i) the transaction may not be subsequently renegotiated;
(ii) the purchaser must be unconditionally obligated to pay for the securities, this obligation to purchase being qualified only by conditions not within the direct or indirect control of the purchaser; and
(iii) the purchase price of the securities may not be based on the market price around the time of the public offering.
We believe that the Commission should clarify in the Release that a permitted condition "that is not within the direct or indirect control of the purchaser" includes customary closing conditions of private placement purchase agreements (such as delivery of legal opinions and officer's certificates).
B. Abandoned Private Offerings Followed by Public Offerings.
Under the Release, issuers eligible to use Form B may make offers prior to filing and are not required to file a Form B until the time of sale of the securities. Accordingly, a Form B issuer could easily transition from an abandoned private offering to a public offering. However, a Form A issuer would face the following conditions before it could commence a public offering after an abandoned private offering:
(i) the issuer would have to notify all offerees that the private placement has been abandoned;
(ii) no securities could be sold in the private placement;
(iii) the issuer must not have engaged in general solicitation or advertising;
(iv) the issuer would have a 30-day waiting period after notification of abandonment if securities were offered to offerees ineligible under Section 4(2), Section 4(6) or Rule 506; and
(v) the issuer must either file the private offering materials as part of the registration statement or notify the offerees that the filed prospectus replaces the private offering materials and all indications of interest are rescinded.
Because the requirements for use of Form B are restrictive, particularly in the context of the high-technology sector, many Silicon Valley firms will be subject to the restrictions applicable to Form A issuers when converting to a public offering from private placement. We believe the restrictions applicable to Form A issuers noted above should be modified to reflect the following:
(x) The notice requirement should either be abandoned or be stated as a "good faith obligation";
(y) The 30-day waiting period for Form A issuers should be eliminated in light of the inherent length of the waiting period and the volatility of market pricing; and
(z) Private offering materials should not be required to be filed as part of the registration statement.
With respect to the notice requirement, we observe that the concept of offeree- based regulation in the context of private placements was abandoned by the Commission decades ago with the adoption of Regulation D. Proposed new Rule 152 would re-introduce the concept of "offeree" into the private placement process. It would create a new and inefficient transactions cost in private placements by requiring that issuers track all offerees, and not just actual purchasers, in order to satisfy this provision of Rule 152. Issuers would be required to incur these costs even though the offerees to be notified would, by definition, not have been purchasers in the abandoned private placement and therefore could not have suffered harm. The restrictions on general solicitation, moreover, provide adequate safeguards against issuers using a private placement to precondition the public market for a public offering.
The thirty-day waiting period for Form A issuers also serves no constructive purpose. The offerees intended to be protected by the proposed waiting period would have the benefit of a registration statement. In addition, these offerees would likely be few in number, particularly in comparison with the size of the public markets in which a public offering would be made. The waiting period itself, which frequently exceeds thirty days for an initial public offering, also acts as a natural brake on the process rendering the thirty-day waiting period additionally unnecessary. The thirty-day waiting period thus promises to raise capital formation costs without generating any offsetting investor protection benefits.
The requirement that the private offering materials be filed as part of the registration statement is also unnecessary and again threatens to raise capital formation costs without generating any offsetting benefits. The issuer will have strict liability for misstatements and omissions in the registration statement as filed. Inconsistencies between the earlier private placement memorandum and the filed registration statement could later be cited by aggrieved purchasers as evidence of a misstatement or omission, should a dispute arise. It is therefore unnecessary that private placement materials be filed with the Commission in order for the issuer to have a powerful incentive to maintain consistent disclosures and to explain material variances between the filed materials and the private placement documents. Instead, as the Commission is aware, private placement materials prepared for sophisticated investors are generally, and reasonably, prepared to different disclosure standards than those applied to registration statements. To subject those private placement materials to Section 11 liability imposes an unnecessary and impractical liability on honest issuers who shift from private placements to public offerings.
C. Abandoned Public Offering Followed by a Private Offering.
Of all the integration proposals under the Release, the treatment of abandoned public offerings is perhaps the most important to Silicon Valley companies. Stock market conditions can change quickly for high-technology companies, and can make it impossible for an issuer to proceed with a planned public offering. When an offering window shuts - often because of market conditions that are unrelated to an individual company's business - the very survival of a company can be at stake. The current uncertainty in this area is of particular concern when we advise our clients on how to quickly raise private capital after an unanticipated delay or cancellation of a public offering.
The Commission's primary concern in this area is that the filing of a registration statement in connection with a proposed public offering of specific securities would constitute a general solicitation for these securities, and thereby make the private offering exemption unavailable. Currently, the clearest safe harbor available to issuers requires that they wait six months to be certain that a private offering of securities, following withdrawal of a registration statement covering the same securities, will not be integrated with the failed public offering. Under the Release, the safe harbor under Rule 152 would permit a private offering after an abandoned public offering if the following conditions are met:
(i) the issuer withdraws the registration statement;
(ii) if the issuer is eligible to use Form B and no registration statement has yet been filed, the issuer notifies all offerees in the public offering that the public offering has been abandoned;
(iii) no securities were sold in the public offering;
(iv) if the private offering is made within at least 30 days after abandonment or withdrawal of the public offering, the issuer notifies each private offering purchaser that:
- the securities are not registered;
- the offered securities in the private placement are restricted securities; and
- investors do not have Section 11 protection under the Securities Act.
(v) if the private offering is made within thirty days of abandonment or withdrawal of the public offering, the issuer and any underwriters accept liability for material misstatements or omissions in the private offering materials under Section 11 and Section 12(a) of the Securities Act.
We welcome the certainty of being able to commence a private offering of securities within thirty days after the withdrawal or abandonment of a public offering for the same securities. We believe, however, that the conditions described above impose unnecessary constraints that increase the cost of the capital formation process without enhancing investor protection. In particular, we recommend the following:
1. There should be no waiting period if objective evidence indicates that the public offering is withdrawn because of general market conditions.
The danger against which the waiting period is designed to protect is the possibility that the public offering process is used or operates as a form of general solicitation in connection with a private placement. As a preliminary observation, given the economic costs and legal risks associated with filing a registration statement with the Commission, and the distinctly different market mechanisms that operate in the public and private markets, we question whether any issuer would rationally begin the public offering process for the purpose of conditioning the market for a private placement. The danger that the public offering process will be used as a part of an effort to engage in a general solicitation for a private placement is further diminished if the Commission can observe that the public offering is withdrawn because of general market conditions over which the issuer has no control.
Accordingly, we suggest that the Rule be amended to provide that there be no waiting period if the withdrawal occurs because of general market conditions. We would be happy to cooperate with the Commission in drafting an objective definition of the "change in general market conditions" that would eliminate the need for any waiting period with respect to any investor.
2. There should be no waiting period for offerings to sophisticated investors such as QIBS or Accredited Investors.
Qualified Institutional Buyers ("QIBs"), investors who are able to fend for themselves by virtue of their familiarity with the issuer and with the capital formation process, and Accredited Investors are sufficiently sophisticated that they do not require the protection offered by a waiting period. In addition, the fear that the general solicitation associated with the filing of the registration statement for the proposed public offering would influence the investment decisions of these sophisticated investors is unfounded. If anything, a company that is required to transition from a public offering to a private placement is generally in a weaker bargaining position and must often make pricing or other concessions to investors willing to participate in the private placement. A waiting period to protect these knowledgeable investors is thus unnecessary under any circumstances, and can have the unfortunate effect of making it far more expensive for high-technology firms to raise capital when they need it the most.
3. The Section 11 and Section 12(2) liability provisions are unnecessary and unwarranted.
The imposition of Section 11 and Section 12(2) liability in the context of a private placement, particularly if it is restricted to sufficiently sophisticated investors such as QIBs, accredited investors, and investors otherwise able to fend for themselves, is entirely unwarranted and unnecessary. As a practical matter, an issuer will typically be able to structure a private placement to close within thirty days of an abandoned offering only if it is dealing with a relatively small number of sophisticated investors who are already familiar with the issuer's business. These investors are not drawn to the opportunity because of road show presentations or other activities related to the offering process, and these are precisely the circumstances in which concern over general solicitation arising from the act of filing a registration statement are unwarranted. Experience suggests that after a withdrawn public offering private placement investors are often able to negotiate favorable pricing and other terms and conditions that effectively protect their interests.
Further, simple disclosure of the anti-fraud protections available under the federal securities laws are sufficient in arm's-length transactions of the sort that accompany private placements occurring after abandoned offerings. This is particularly true in the context of a "busted" offering where market circumstances may have shut an IPO window on an issuer, thereby giving rise to substantial bargaining power in the hands of the private placement investors who are ready to make a significant investment within thirty days. The enhanced bargaining power in the hands of these investors typically manifests itself through more favorable pricing for the investor and the ability to negotiate other favorable terms and conditions, including warranties and representations as may be necessary and appropriate to the conditions of each transaction. The imposition of unnecessary forms of inflexible statutory liability into separately negotiated private placement transactions was not contemplated by Congress in the design of the federal securities laws. The introduction of such a requirement can only lead to sub-optimal contracting among sophisticated and knowledgeable counterparties.
4. The Notification Provisions are Unnecessary.
The requirement that offerees be notified of the abandonment of a public offering is unnecessary. The concept of tracking "offeree" status as a condition to compliance with private placement provisions of the federal security laws was correctly abandoned by the Commission decades ago with the adoption of Regulation D. Offerees who do not purchase cannot be defrauded as a consequence of a withdrawn public offering. Moreover, as a practical matter, it would be extraordinarily expensive - if not impossible - to keep track of all individuals who might be "offerees" so that they could later be informed of the withdrawal of an offering. It also strains credulity to believe that the Commission would require issuers to keep track of offerees in a public offering process only so that they could later be informed that the public offering has been withdrawn and that they are no longer offerees. Such regulations impose unnecessary costs on capital formation. The integrity of the capital formation process is, instead, efficiently promoted by full and fair disclosure to purchasers in the subsequent private placement.
5. The Act of Filing Should Not Trigger the Restrictions of the Proposed Rule.
Given the delays that can be involved in the public offering process, we believe it unnecessary to presume that the act of filing a registration statement is tantamount to a public solicitation. As a practical matter, the act of filing can precede any marketing efforts by a significant time period, and the market is not invariably conditioned by the mere act of filing. Further, given the legal exposure and financial cost associated with the preparation of a registration statement, the level of scrutiny inherent in SEC review, and the potential negative implications associated with an abandoned offering, we find it highly implausible that an issuer would file a registration statement in order to solicit investors or precondition the market for a private placement. Accordingly, any waiting period conditions or other limitations of the rule are most suitably triggered, if at all, by the initiation of actual marketing activity. Such activity can be measured by the circulation of preliminary prospectuses and a variety of other objective indicators other than the filing of a registration statement.
III. Limitations on Short-Form Resale Registration Statements.
Currently, if an issuer has been public for at least one year and is current in its Exchange Act reports, then the issuer may use a short-form registration statement on Form S-3 in two instances: (1) primary offerings if the issuer has a public float of at least $75 million, and (2) secondary offerings (a "resale S-3"), regardless of public float. The Release proposes to restrict the use of Form B, the successor short-form registration statement, to registrants who currently qualify for a primary offering on Form S-3, with slight modifications. This change will adversely affect the ability of smaller public companies, and of companies in industries that are currently out of favor with Wall Street, to register secondary offerings.
The resale S-3 is a very useful financing tool that has been in place since 1972. In our view, restricting the use of the resale S-3 in the manner proposed would have a serious adverse impact on smaller public companies, particularly newer public companies in the information technology and biotechnology sectors common in Silicon Valley.
A. Limiting the Use of Resale S-3's Would Limit the Availability of Private Placement Financings and Increase Financing Costs.
The Commission apparently believes that resale S-3's have been subject to abuse by certain registrants as a "conduit" for disguised primary offerings. However, as currently proposed, the Release would also prohibit the use of resale S-3's by smaller public companies in financing transactions where shares are not resold in an abusive manner. Small public companies in sectors currently out of favor in the public markets (e.g., biotechnology) must frequently use private placements to finance their operations because the market will not support underwritten public offerings. The ability to provide liquidity to investors in private financings through a post-offering resale S-3 makes these private offerings more attractive to investors, reduces the "haircut" the investors require because of the illiquid nature of the shares they receive, and thereby increases the value that the issuer is able to obtain for its securities. The higher value, in turn, promotes the interests of the existing community of public investors who rationally prefer that the issuer receive the higher price and minimize the discount necessary to raise capital in the private markets.
We believe that the loss of the resale S-3, without providing a satisfactory alternative, could severely restrict the availability of private placement financings for these companies and significantly increase financing costs in the form of greater discounts from current market prices. In no event would the elimination of the resale S-3 promote the interests of existing public investors in companies that rely on the availability of Resale S-3's, or of private placement investors willing to put more capital at risk to support the company's endeavors.
B. The Form Available to "Seasoned" Form A Issuers (Roughly Equivalent to the Current Form S-2) is an Unsatisfactory Alternative to the Current Resale S-3.
The new "seasoned issuer" Form A would be available only to companies with public floats of at least $75 million that have been public for at least two years. The new form would have cumbersome document delivery requirements and would be available only with "underwriter concurrence," a new concept that will be difficult to interpret in the context of shares received in a private placement that may not have involved an underwriter or placement agent and that are intended to be resold into the public market without the use of an underwriter.
In addition, the proposed new Form A for "seasoned" issuers would permit filers to incorporate by reference only those Exchange Act documents filed prior to the effective date, not documents filed subsequent to effectiveness. Although an issuer could file post-effective amendments to incorporate future filings by reference, this procedure is time-consuming and imposes greater expense on the issuer without providing any meaningful additional information to potential investors. Indeed, we believe that the lack of forward incorporation by reference accounts, in material part, for the current lack of popularity of Form S-2. The ability of a company automatically to incorporate its future Exchange Act filings by reference during the resale period is an important advantage of current Form S-3. We believe that a resale Form A is an unsatisfactory alternative that will severely restrict capital-raising opportunities for small issuers.
C. Requiring Delivery of Financial Reports is Burdensome and Unnecessary.
Given the wide availability through the internet of documents filed via EDGAR and the cost of providing paper copies, we fail to see the value of requiring physical delivery of quarterly and annual reports in the proposed "seasoned issuer Form A." Requiring physical delivery of documents also appears inconsistent with the Commission's recent releases permitting and encouraging electronic delivery.
D. The "Special Offering Exemption" for Form B Frequently Will Not Be Available.
Typically, investors in private financings of smaller technology-driven public companies are accredited individuals or institutions. These investors are capable of fending for themselves. Many of them will not, however, qualify as QIBs, and many often are not current shareholders. The "special offering" exemptions proposed for the use of Form B would thus not be available for many typical investors in such financings. We believe that the pool of potential investors for such private financings would be severely reduced if an economically reasonable means of public resale were not available.
E. Limits on Resale S-3's Will Provide an Unintended Advantage to Larger Issuers.
Many public companies use resale S-3's to cover the resale of shares issued under the private placement exemption as part of the acquisition of companies with a small number of shareholders. This has proven to be a cost-effective alternative to Form S-4 where the original issuance can otherwise qualify for an exemption. Restricting the use of Form B for secondary offerings to larger companies gives them an unfair and, we believe, unintended advantage in negotiating acquisitions of smaller companies, again with no discernible improvement in the information available to investors. Indeed, to the extent that the federal securities laws are intended to act as neutral disclosure standards that favor neither large nor small issuers, provided that their disclosures are full and fair, this proposed provision of the rule has an effect contrary to the statute's intended purpose.
F. Existing Contractual Registration Rights Will be Affected.
Many public and private companies have registration rights in place that presupposes the availability of a resale S-3. Some of these companies, bound by existing agreements that did not anticipate a change in S-3 availability, might be forced to reply upon prohibitively expensive resale Form A registration statements. Other companies might find themselves in disputes with investors over the terms and conditions of financings that were entered into on the good faith assumption that resale S-3 registration would be available. We do not believe that the Commission intends to trigger such disputes among issuers and investors, or to impose such unanticipated costs. Nonetheless, these undesirable consequences are inevitable given the current structure of the Commission's proposal.
IV. Internet-Based Communication During the Offering Process.
The Release suggests that existing securities laws can inhibit communications between issuers and investors. The new proposals seek to remove many of the present restrictions in an effort to allow issuers and investors to communicate more freely during an offering, but they do so on terms and conditions that render the entire proposal unattractive to issuers.
In particular the Release proposes to establish a series of bright-line safe harbors for certain disclosures made during the pre-filing period and suggests that these proposals would allow issuers to more effectively utilize and monitor their internet use throughout the entire offering process. According to the Commission, the proposed safe harbors will provide issuers with guidance for determining what information may be posted on web sites during the thirty-day quiet period. In addition, the Release allows issuers to deliver information to prospective investors during the waiting period without having to comply with Section 10 of the Securities Act. The Release suggests that issuers will have the freedom to:
(i) use the internet and other electronic media to conduct road shows for institutional and retail investors without the use of passwords;
(ii) use e-mail to answer investors' questions regarding the company and the offering;
(iii) use "chat room" discussions to communicate with potential investors, and post offering related messages on electronic bulletin boards.
Although we agree that allowing greater freedom to communicate during the offering process can benefit issuers and investors alike, we are convinced that the new regulatory regime proposed in the Release will have the unintended and undesirable consequence of dramatically reducing the flow of information into the market. The proposed rules may also require issuers to file with the Commission information that is currently on their web sites and that is not currently subject to Section 11 liability. The increased liability that would attach to such filings will, in our experience, undoubtedly result in a reduction in the amount of publicly available investment information as issuers cut back on disclosures that are not mandatory and that would carry significant litigation risk.
A. The Release Does Not Take Into Consideration the Impact These Proposals Will Have on Form A Companies Who Rely on the Internet for Sales and/or Customer Communications.
Under the new rules, companies will be forced to file significant portions of their web sites with the Commission. Filing these documents, however, will be burdensome to many issuers because web sites are often evolving, dynamically updated documents that would require continuous filings. Continuous filings would be especially burdensome to internet companies because web site communications involve not just text, but also audio, video, and high-resolution graphical images. EDGAR, however, does not accept audio, video, or graphical image filings. It accepts only "fair and accurate" narrative description of the materials delivered to investors. The increased legal analysis necessary to ensure Exchange Act compliance for a continuous filing of web site materials would inflate issuers' costs and negatively affect the overall operating efficiency of these companies.
B. The Release Does Not Adequately Define, or Efficiently Apply, the Safe Harbors Provided.
Although the safe harbors contained in proposed Rules 168 and 169 address some of the uncertainties encountered by our clients during the offering process, many of the items commonly appearing on their web sites will not be covered. Under the Release, issuers would be allowed safe harbors for "factual business communications" and for "regularly released forward-looking information." The Release, however, does not sufficiently define the protections provided. For example, there remains a question as to the scope of the "factual business communications" safe harbor and is unclear as to whether information such as proposed product launches and upgrades will be protected.
Further, the inability of unseasoned Form A issuers to make statements regarding "plans and objectives for future operations, including plans or objectives relating to the products or services" will be problematic for companies engaged in electronic commerce ("e-commerce") and those providing internet portal services (i.e., companies for whom their product or service is a web site). The proscribed statements and descriptions are, for many of these companies, the primary vehicle for generating sales and capturing market share.
While the safe harbor categories provided for in the Release are essentially the same as those defined in the current safe harbor for forward-looking statements, the present regime does not require that statements falling outside the safe harbor be filed with the Commission. If the Release is adopted in its present form, unseasoned Form A companies will be faced with a choice of either filing their communications with the Commission or refraining from releasing the information at all. Given a choice between filing more information with the Commission, or disclosing less information to the public, it is our strong belief that issuers will choose the latter course of action.
The desire to limit potential litigation exposure will therefore cause some e-commerce and internet portal companies to alter their products and services significantly during the offering period. For some companies the effect may be the removal or monitoring of chat room and bulletin board functions on the site, functions that may be central to these companies' business models. For others, the restrictions on statements made by Form A companies regarding future plans related to products and services could diminish these companies' ability to compete in fast moving markets. In either event, the restrictions will negatively impact the performance and viability of these issuers, which in turn will impede the process of efficient capital formation.
As a result, we request that the Commission consider modifying the safe harbors to allow certain companies, especially unseasoned, internet intensive, Form A issuers, to continue their established business practices as long as they can demonstrate that compliance with the new rules would adversely affect their ability to compete.
C. The Requirement That Issuers File With the Commission All Free-Writing Materials Used During the Offering Will Have a Chilling Effect on Issuer/Investor Communications.
In our view, forcing issuers to file internet-related free writing will create a tension between the issuer's desire to communicate with investors and the desire to avoid increased liability under the federal securities laws. Because liability would attach to all written communications, but not oral communications, issuers may forego all internet-related free writing in favor of face-to-face oral communications. Imposing liability on issuers for electronic road show and web site communications will reduce the amount of publicly available information and may encourage selective oral disclosure. Broadening the filing requirements in the manner proposed will, contrary to the stated goal of the Release, ensure that access to important investment information will be restricted to select groups of investors and analysts rather than being disseminated to retail investors.
We understand that the Commission is working on a separate "internet release" concerning, among other matters, issuer web site practices during the pendency of a public offering. We recommend that the Commission defer any significant rulemaking concerning offering materials until it has received comments on the internet release.
D. The Release Proposals May Conflict With Current SEC Policy Regarding the Posting of Prospectuses on the World Wide Web.
At present, issuers are free to post their prospectuses on the web as long as the document is self-contained (i.e., kept within a single electronic envelope). Hyperlinking information in a posted prospectus may have the effect of incorporating the linked information into the document. If issuers are required to file significant portions of their web sites with the Commission, they may be faced with a choice of either stripping all hyperlinks from their sites during the offering, or assuming the increased liability for the linked information.
This increased liability may cause some issuers to simply remove the hyperlinks from their sites or refrain from using the internet during the offering. But for many internet intensive issuers this would not be possible because the removal of all hyperlinks or the freezing of the site would be tantamount to shutting down the business. As a result, internet intensive issuers could be forced to assume increased liability simply to remain in business during the offering.
In our view, the current anti-fraud provisions of the Securities Act and the Exchange Act are sufficient to serve the Commission's goal of investor protection. Absent a major change in issuers' existing web site disclosure practices, the Commission should not require that all internet-related materials be filed as part of the registration statement.
To address the Commission's concerns and to continue foster the growth of the internet, issuers should be allowed either to set up a separate site for offering-related materials or to create a separate area for this information on their main site. Partitioning the main site so as to allow a link to the offering information would not violate the spirit of the Commission's single electronic envelope requirement, as long as issuers insert a legend into the page containing the offering hyperlink alerting potential investors to the fact that the information on the main site is not intended as an offer to buy securities and that the issuer does not intend to file any main site information with the Commission. Such a legend could read as follows:
THE COMPANY IS CURRENTLY IN REGISTRATION.
WITH THE EXCEPTION OF THE WEB SITE HYPERLINKED BELOW,
THE INFORMATION CONTAINED IN THIS SITE DOES NOT CONSTITUTE
AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO BUY,
ANY SECURITIES OF THE COMPANY
E. The Requirement to File Materials "on or Before the Date of First Use" Could Prevent Utilization of Innovative Technologies During the Offering.
In order to utilize the internet technologies described in the Release (e.g., electronic road shows, e-mail, and chat room discussions), issuers would be required to file these materials with the Commission on or before first use. This new filing requirement, however, will make it difficult or impossible for issuers to utilize interactive internet technologies during the offering process because, by the very nature of internet interactivity, significant portions of the materials that would have to be filed would not even exist prior to first use, and many would be in a state of almost constant modification.
On a more detailed level, the requirement that all free-writing materials be filed with the Commission "on or before the date of first use," creates special problems for west-coast firms. Because of EDGAR's present filing schedule, Silicon Valley companies will have to file all updates and web site changes with EDGAR no later than 2:30 p.m. Pacific Time on the date of first use. This constraint will make it difficult for Silicon Valley issuers to conduct interactive road shows or chat room discussions during the evening hours when individual retail investors are available. Silicon Valley issuers could file the scripted portions of their presentations prior to the event, but because EDGAR does not accept audio or video filings, the interactive segments of the presentations will have to be transcribed prior to submission. The legal analysis necessary to ensure a "fair and accurate narrative description" of the materials may limit the possibility of filing on the date of first use. Filing after the date of first use, however, would be a violation of Section 5 of the Securities Act, as amended. As a result, Silicon Valley issuers will be reluctant to utilize interactive internet technologies during the offering period.
V. Proposals Relating to Exchange Act Disclosures
The Commission's proposals relating to Exchange Act disclosures are intended to enhance the quality and timeliness of information contained in periodic reports. Many of the proposals will, we believe, prove unworkable even for large, established issuers. Many more will be viewed as overly burdensome, particularly for smaller companies and newly formed public companies. Many smaller high technology companies located in the Silicon Valley do not have in-house legal staff and rely heavily on outside counsel to comply with reporting obligations. In addition, their finance and reporting departments, unlike those of large, seasoned companies, often struggle to keep up with current filing requirements and would be disproportionately burdened by the proposed new rules.
A. Delegation is Essential to the Efficient Operation of all Large Organizations and is Expressly Contemplated by the Corporate and Securities Laws.
The Release appears to be motivated in material part by a skepticism over the extent to which issuers currently delegate responsibility for compliance with Exchange Act reporting requirements. Delegation is, however, expressly contemplated by the structure of Section 11, which recognizes that there may be expertised portions of registration statements and which establishes different standards of liability for inside and outside for directors and for other parties who participate in the preparation of registration statements. Further, corporate law permits broad delegations of responsibility for the review and preparation of corporate filings. Indeed, the Commission itself has in place an extensive procedure for the delegation of responsibility through various levels of the staff, and Commission review of many legal filings, orders, and other agency actions is not required by the Commission itself. Delegation is thus not inimical to the structure of the securities and corporation laws. To the contrary, delegation is expressly contemplated by those laws, and those laws recognize that delegation is essential to the efficient operation of all large organizations.
To the extent that the Release proposes to restrict the ability of issuers to delegate responsibility for compliance with the federal securities the Release will inefficiently increase the costs of compliance. At no point do our observations suggest that issuers should be subject to weaker disclosure standards or that the current anti-fraud regime be watered down. Instead, the essential observation is that organizations must be permitted to delegate according to the facts and circumstances of their individual situations in order to achieve efficient compliance with the statute's anti-fraud provisions.
B_ Requiring Certification is Unnecessary and Impractical.
The Release would require all signatories to Exchange Act documents to certify that: (1) he or she has read the Exchange Act registration statement or report; and (2) to his or her knowledge, the report contains no material misstatements or omissions. We believe that this requirement is unnecessary and potentially damaging.
The Release observes that there is a difference in the quality of disclosure between Securities Act filings and Exchange Act filings and suggests that a certification requirement will reduce this difference. We disagree. The root cause of the discrepancy between Securities Act filings and Exchange Act filings arises from the significantly greater expense and delay associated with the preparation of Securities Act filings. That expense and delay is, in turn, driven by heightened Securities Act liability standards and staff review. Unless the agency seeks to impose the same level of expense and delay on Exchange Act filings as on Securities Act filings - a result that would dramatically increase the costs of periodic reporting - the discrepancy will, and rationally should, remain. The primary consequence of the certification requirement will instead likely be an increase in litigation exposure, with all of litigation's concomitant costs, without a corresponding increase in the quality of disclosure.
Documents filed under the Exchange Act are already subject to liability under Rule10b-5 and/or Section 18. The standards for liability under these provisions have been refined by years of case law interpretation as to the requisite state of mind, the definition of materiality, and so forth. None of these critical qualifications are captured in the language of the proposed certification.
Moreover, as a practical matter, it is extremely difficult for directors to review the final draft of an Exchange Act document. Typically, a draft of the Form 10-K is sent to all directors for their review and signature, even though revisions and corrections may be made up until the actual date of filing. A director should not be required to sign a certification that he or she has read the filed document when that will almost never be the case. Instead, directors should rationally be permitted to rely on appropriately delegated responsibility to corporate officers and advisers.
Accordingly, the real effect of a certification requirement would be to give a plaintiff's lawyer an opportunity to embarrass a director who reasonably relied on delegated responsibility by pointing to a portion of an Exchange Act report that the director cannot recall or that was not in the document at the time the director read it. We, therefore, strongly oppose the addition of a certification requirement. We also reiterate that the liability associated with Exchange Act filing is not weakened one iota by the absence of a certification requirement.
C. Requiring Directors to Sign Quarterly Reports is Unworkable.
The Commission is proposing to expand the number of persons required to sign quarterly reports on Form 10-Q and Form 10-QSB and Exchange Act registration statements on Forms 8-A, 10, and 10-SB to include the same persons who are required to sign a registration statement filed under the Securities Act. Specifically, the document would be signed by the registrant, the Chief Executive Officer, the Chief Financial Officer, the Chief Accounting Officer, and a majority of the Board of Directors.
The requirement that a majority of the directors sign a quarterly report on Form 10-Q or 10-QSB is unworkable. Although a year-end schedule does allow enough time for directors to actually receive and review the Form 10-K, there is no such luxury with respect to a quarterly financial period. Draft financial statements are often not available until the third or fourth week following a quarter's end, after which a draft of the Form 10-Q is prepared. A draft is then typically circulated to outside lawyers and outside accountants for comment. Revisions are then made and the report is typically filed shortly before the due date, 45 days after the calendar quarter. In such a short time frame, our experience suggests directors would often be difficult to reach due to travel schedules or business or other scheduling conflicts. These constraints may be especially problematic for companies with directors who maintain very busy schedules. The directors should be permitted to rely on the chief financial officer, the in-house finance and accounting staff, the outside accountants and Company lawyers to prepare and file the Form 10-Q in a timely manner. Directors should not be required individually to sign the Form 10-Q, nor (as discussed above) should they be required to certify that they have read it and that there are no misstatements.
It is already very difficult to find qualified persons who are willing to serve as directors of high-technology companies, which tend to have high stock price volatility and are frequently the subjects of securities class action lawsuits. Adding the additional obligation and potential liability of reviewing and signing off on quarterly reports will most likely result in even fewer persons being willing to serve as directors, and those that are willing to serve will rightfully demand higher compensation to do so. We do not believe that this is a positive result.
D. Risk Factors Should not be Required as a Stand-Alone Section.
The Commission has proposed to extend the requirement for risk factor disclosure to Exchange Act registration statements and periodic reports. The practice of risk factor disclosure is not inherently objectionable and many of our client companies already include risk factors in one form or another in their Forms 10-K and 10-Q. This has been particularly true since the adoption of the Private Securities Litigation Reform Act of 1995. Registrants who wish to avail themselves of the safe harbor for forward-looking statements made orally can easily refer to the most recent periodic report for appropriate risk factors if they are contained in such reports. However, the Commission should consider permitting registrants to weave the risk factor disclosures into the fabric of the Business section (for Form 10-K) or the Management's Discussion and Analysis section rather than forcing a stand-alone section typically found in registration statements filed under the Securities Act.
E. Quarterly Financial Statements Should not be Treated as "Filed" Under Section 18 of the Exchange Act.
Current Rule 13a-13(d) exempts the financial information contained in Part I of Form 10-Q and Form 10-QSB from being considered "filed" under Section 18 of the Exchange Act. The Release proposes to revise these rules to treat as filed the financial statements and the MD&A disclosure (but not the market risk disclosure) in these quarterly reports. We do not believe that this treatment is appropriate for information contained in a quarterly report.
Financial statements contained in quarterly reports are not audited. They must be prepared by management in good faith, but should not be elevated to the same level of liability as applies to audited financials in the annual report. Moreover, because of the shorter time frame for a quarterly report, the MD&A necessarily does not receive the type of review and scrutiny applied to an annual MD&A in a Form 10-K or to an MD&A (annual or quarterly) in a registration statement under the Securities Act. It is simply not possible or efficient to bring to bear the resources that go into the preparation of a Securities Act filing on the preparation of a regular quarterly MD&A for a Form 10-Q. The Rule 10b-5 standard of liability is an appropriate standard of liability for both the financial statements and the MD&A in a quarterly report.
F_ Due Dates on Periodic Reports Should Not be Accelerated.
The Commission has solicited comment as to whether the due dates for annual and quarterly reports should be accelerated. We respond with an unequivocal no.
As noted above, the Form 10-Q is typically only ready for filing shortly before (sometimes on) the 45th day following the end of a fiscal quarter. Acceleration of this due date would result in poor disclosure and more late filings, thereby throwing the registrant into a long-form registration statement mode under the Securities Act. If the Commission adopts the director signature requirement (against our recommendation), this would also make it far more difficulty to file a Form 10-Q at an earlier date.
With respect to the Annual Report on Form 10-K, it is our experience that clients take this disclosure document very seriously. In order to prepare the disclosures, they go through a number of review cycles that include both internal reviewers and outside counsel and auditors. At the same time, the registrant is trying to prepare its annual report to stockholders and its proxy materials. Compressing the time period for the Form 10-K would put an unnecessary additional burden on all registrants and would disproportionately hurt smaller registrants with fewer resources. It would also be likely to result in poorly crafted disclosures.
The suggestion that due dates be accelerated is thus fundamentally inconsistent with the Commission stated objective of achieving greater care and precision in the preparation of Exchange Act filings. For these reasons, we urge the Commission not to accelerate the due dates on periodic reports.
G. Revisions and Additions to Form 8-K Generally Should Not be Adopted.
Earnings Release. The Release proposes to require the filing of summary annual and quarterly financial information on a Form 8-K by the earlier of: (1) public release of such financial information (such as is frequently done in an earnings release); or (2) a specified number of days after a period end (thirty calendar days after the quarter end or sixty calendar days after fiscal year end). If a registrant does an earnings release prior to the filing of its Form 10-Q (as many do), we would not object to a requirement that such information be filed in a Form 8-K. However, we question the necessity of such a filing, given the broad distribution of press releases and the availability of such information on the internet, both through the registrant's web site and media web sites.
We do not believe that the Commission should adopt a rule forcing early disclosure of financial information. A filing should only be required if the registrant voluntary publishes an earnings release and does so prior to the filing of its Form 10-Q. Even companies that typically release their earnings two or three weeks after quarter-end from time to time will be engaged in discussions as to an accounting issue that will affect the reported results for a quarter. The registrant should not be forced to file a Form 8-K with summary financial information when it has chosen not to do an earnings release for good reason, such as an outstanding accounting issue that is in the process of being resolved.
Acceleration of Due Dates on Existing Items. The Commission is proposing to shorten the due dates for filing a Form 8-K from the current standard of 15 calendar days for most (five business days for a few) to five calendar days for most and one business day for a few. This proposed acceleration of due dates for Form 8-K would render timely filings extremely difficult in most cases and impossible in some. For example, a one-business day deadline would often be impossible to meet. Keep in mind that the chain of events is generally as follows: an event occurs, someone at the company who is aware of the event realizes that it triggers a filing requirement, disclosure is drafted, disclosure is reviewed by outside counsel and possibly an outside accounting firm, disclosure is revised, the document is filed. This chain of events, which is inevitable, almost never occurs during the course of one business day and frequently could not occur so quickly.
In particular, current Form 8-K, Item 4, requires the reporting of a change in accountants. This due date is proposed to be reduced from five-business day to one business day. It would be virtually impossible for most registrants to be able to make a timely filing under this item, especially given the fact that it requires an exhibit from the accountants, which typically takes several days to obtain. The same is true of current Item 6 regarding resignation of directors, which also requires an exhibit from the director.
New Form 8-K Items. The Release proposes to move two items that are currently required by Form 10-Q to Form 8-K. Material modifications of the rights of security holders is currently treated as required disclosure by the Form 10-Q pursuant to Item 2(a) and (b) of Part II. Accordingly, these modifications must be disclosed within 45 calendar days after the end of the quarter in which the modifications occur. The Release would accelerate that to a Form 8-K that would be required to be filed within five calendar days after the event. This is much too severe a shortening of the time within which such event must be reported. While we do not object to moving the item to Form 8-K, the due date should be 15 calendar days after the event.
The Release also proposes to move the item regarding default on senior securities from Item 3 of Part II of Form 10-Q to Item 11 of Form 8-K. This is very problematic. In order to establish a superior negotiating posture, banks and other lenders often send out notices of default that are, at best, questionable. Banks and other lenders may then use the notice as the beginning of a negotiation as to whether or not the issuer is in default, and whether a waiver will be granted. Even if the default notice is well founded, the parties typically work together to arrive at a waiver or cure that is acceptable to both parties by the end of the quarter. If reporting of the notice of default is required on a current basis (whether within one business day as proposed or within 15 calendar days), it can result in unnecessarily alarming the public and potentially causing a "whiplash" effect in the stock price. When the Form 8-K is filed announcing the notice of default, the stock price may be adversely affected, and the stock price may not recover when the waiver or cure is agreed to, as subsequently reported in the Form 10-Q. Accordingly, we believe that this requirement should not be moved to the Form 8-K.
The Release further proposes to add three completely new disclosure requirements to Form 8-K: (1) departure of key officers (new Item 12); (2) name change (new Item 13); and (3) auditor notification of non-reliance on prior audit opinion (added to existing Item 4). We generally agree that disclosure should be required of these events. However, as noted above (and particularly in light of the fact that these are new disclosure items), the due date should be 15 calendar days, not one business day (Items 4 and 12) or even five calendar days (Item 13).
With respect to the departure of the Chief Executive Officer, Chief Financial Officer, Chief Operating Officer, President or any person serving an equivalent function, we suggest that disclosure only be required of the event, the date that it occurred, and any replacement that has been identified. The proposed requirement in Item 12(b) to "indicate the reason for his or her departure" should not be required as a line item disclosure. There are often very complicated reasons for a key officer's departure, and there are also typically ongoing severance negotiations. It may not be possible to ascertain the reason for an officer's departures, and the reason given by the officer may be subject to dispute. Often as a condition to a severance agreement, both parties agree not to comment on the reasons for departure. The issuer should not have to take on potential liability relating to the disclosure of the reason for the departure. If there is truly some fundamental underlying problem in the issuer's business, its disclosure will be required by other items (such as MD&A) or by the general materiality standard.
A name change, while not currently required as a numbered item disclosure, is required to be disclosed on the cover of the first Form 10-Q or Form 10-K filed after the change. We question whether a name change has the significance and urgency of the other proposed new items, and suggest that it either be left as is on the cover pages of periodic reports, or alternatively that the period for filing it on Form 8-K be 15 calendar days.
Notification by the auditors of non-reliance on a prior audit report is a significant event and deserves to be incorporated into Form 8-K. While we would prefer a due date of 15 calendar days after the event, we concur that it would not be unreasonable to require filing within five business days (not calendar days) of the event, as is now the case for a change in accountants.
VI. Procedures for "Test-the-Waters" Proxy Solicitation.
We support the promulgation of a "test the waters" exemption along the lines discussed Release 33-7607 (Regulation M-A). We believe that such an exemption will meaningfully expand the circumstances under which issuers may lawfully consult with their stockholders, and that this expansion is in the interest of the entire investment community.
A. Issuers Should be Able to Consult with Stockholders Before Beginning Proxy Solicitation.
We have long had an interest in this issue. One of our signatories wrote to the staff in 1997 supporting an amendment to the proxy rules that would permit "testing-the-waters." An issuer often considers business transactions requiring stockholder approval where it would be extremely valuable for the issuer to be able to consult with its largest stockholders, who are not represented on the board, in order to gauge their willingness to vote in favor of the transaction if it were proposed. Because serious questions existed as to whether such consultations would be permitted under the proxy rules, the issuer typically refrains from communications and, instead, proposes the transaction "blind." The issuer files a proxy statement or a Form S-4 Registration Statement and makes its arguments in favor of the transaction on the basis of the disclosures contained therein. The issuer simply hopes that those arguments will prevail on their merits but with no guidance as to the likelihood of that outcome. The costs of preparing a proxy statement or registration statement would be saved and management time and attention could be more appropriately focused on other matters if an issuer could consult on a limited basis with significant shareholders about a proposal and determine early on that such a proposal had no chance of success.
A typical example in this case of stock option and other types of equity incentive plan proposals about which issuers might wish to submit to their stockholders for a variety of reasons. Given the current climate of institutional stockholder activism, votes on these proposals have in many instances become quite controversial. It would be a significant benefit to all parties if an issuer, rather than having to decide unilaterally on the terms of a plan and then take its chances on winning approval, could confer with its institutional stockholders ahead of time and structure a plan that is designed to satisfy, in advance, concerns that might be voiced in the consultation process.
In our view, issuers should not have to take this kind of calculated risk. Rather, they should be able to consult with their stockholders before embarking upon an expensive, time-consuming, and potentially divisive proxy solicitation.
B. Issuers Should Not be Required to Make a Filing as a Condition to "Testing-the-Waters".
We oppose any requirement that an issuer make a filing (even a notice filing) as a condition to its being allowed to "test-the-waters." If an issuer is required to reveal the substance of a proposal under consideration, the result would unnecessarily inhibit the consultation process with stockholders because it could force disclosure of premature or ill-formed proposals. If, on the other hand, the issuer is required to make a notice filing that did not disclose the substance of a proposal under consideration, such a filing could give rise to harmful speculation. If the Commission is concerned that unlimited "testing of the waters" would give rise to abuse, a far preferable alternative to a filing requirement would be a limitation similar to the ten-person limit of Rule14a-2(b)(2), which would enable the issuer to consult with those stockholders whose holdings were sizable enough, or whose influence was far-reaching enough, to impact the vote on the proposal.
C. Subsequent Delivery of a Proxy Statement Should Not be a Condition to "Testing the Waters".
We are also opposed to conditioning the rights to "test-the-waters" on the issuer thereafter delivering a proxy statement. The issuer should be free to decide not to proceed with the proposal if the information it obtains from consulting with stockholders leads to the conclusion that the proposal should be abandoned prior to the preparation and filing of a proxy statement. We believe that any potential abuses in a broad "test-the-waters" exemption would be adequately addressed by the prohibition on the delivery of a proxy card other than in tandem with a definitive proxy statement, and we do not think that any formal "cooling-off period" is required in order for the prophylactic purposes of this prohibition to be accomplished.
D. Existing Proxy Rule Exceptions Should Not be Replaced by an Exception for "Testing-the-Waters".
We do not believe that a broad exemption of this type would remove the need for any of the current exemptions under the proxy rules. Those exemptions have evolved over the years to respond to very specific concerns and they should be left in place. Permitting an issuer to "test-the-waters" should not be coupled with (or replace) those exemptions, particularly if, as we propose, the "testing-the-waters" exemption is not conditioned on the issuer making any filing unless and until it decides to solicit proxies in favor of a specific proposal.
***
While we are able to support certain portions of the proposals contained in the Release, especially those relating to voting lock-up agreements under proposed Rule 159 and integration of private and public offerings under proposed revisions to Rule 152, we believe that even these proposals require modification to achieve their intended purpose. We have serious reservations about many of the other proposals contained in the Release. We urge the Commission to carefully consider significant revisions to the Release in light of the comments in this letter, and not to proceed with material portions of the Release.
Thank you for your consideration of the foregoing.
Respectfully yours,
/s/ Joseph A. Grundfest
Joseph A. Grundfest
William A. Franke Professor of Law and Business
Stanford Law School
Stanford, CA 94305
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/s/ Armando Castro
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/s/ James Jones
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/s/ Scott Spector
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/s/ Paul Blumenstein /s/ Diane Holt Frankle
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/s/ Richard A. Peers /s/ Henry Lesser
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/s/ Linda M. DeMelis
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/s/ Ann Yvonne Walker
/s/ J. Robert Suffoletta
/s/ Michael A. Occhiolini
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