UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES ACT OF 1933 Release No. 7423 \ June 18, 1997 ADMINISTRATIVE PROCEEDING Release No. 3-9333 In the Matter of GFL ULTRA FUND LTD., Respondent ORDER INSTITUTING PUBLIC PROCEEDINGS PURSUANT TO SECTION 8A OF THE SECURITIES ACT OF 1933, MAKING FINDINGS AND ORDERING RESPONDENT TO CEASE AND DESIST I. The Securities and Exchange Commission (the "Commission") deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted against GFL Ultra Fund Ltd. (the "Fund") pursuant to Section 8A of the Securities Act of 1933 (the "Securities Act") to determine whether the Fund violated Section 5 of the Securities Act.<(1)> II. In anticipation of the institution of these administrative proceedings, the Fund has submitted an Offer of Settlement which the Commission has determined to accept. Solely for the purposes of these proceedings and any other proceedings brought by or on behalf of the Commission or to which the Commission is a party, prior to a hearing pursuant to the Commission's Rules of Practice, and without admitting or denying the facts, findings, or conclusions herein, the Fund consents to entry of the findings, and the imposition of the cease-and-desist order set forth below. III. FINDINGS <(1)> Section 8A provides in relevant part that "[i]f the Commission finds . . . that any person is violating, has violated, or is about to violate any provision of this title, or any rule or regulation thereunder, the Commission may publish its findings and enter an order requiring such person . . . to cease and desist from committing . . . such violation and any future violation of the same provision, rule, or regulation." ======END OF PAGE 1====== On the basis of this Order and the Fund's Offer of Settlement, the Commission finds<(2)> the following: A. Background GFL Ultra Fund Ltd. is a British Virgin Islands corporation in the business of investing in securities. In April 1994, the Fund was incorporated and began engaging in various trading strategies which had been initiated by a related entity in April 1993. This related entity had ceased these trading strategies when the Fund assumed them. The Fund continued the trading strategy relevant to this Order, which was its primary strategy, through January 1995.<(3)> (Hereinafter, conduct ascribed to the "Fund" in this Order was engaged in by either GFL Ultra Fund Ltd. (during the period April 1994 through January 1995) or the related entity (during the period April 1993 through May 1994), unless otherwise specified.) The relevant strategy involved (i) purchasing for cash securities overseas which had been issued at substantial discounts and without registration pursuant to Regulation S,<(4)> (ii) hedging some or all of those securities through short selling in the United States before and/or during the 40-day restricted period under Regulation S (as discussed below), and (iii) unwinding the short positions, which involved covering the short positions using the Regulation S shares or selling the Regulation S shares in the open market in the United States after the 40-day restricted period had expired. This strategy resulted in a profit for the Fund when the Fund unwound its positions. Indeed, when the Fund took offsetting long and short positions, its profits were locked in, except in the unlikely event that conditions made it impossible for the Fund to <(2)> The findings herein are made pursuant to the Offer of Settlement submitted by the Fund and are not binding on any other person or entity. <(3)> Neither the related entity nor the Fund is registered as an investment company under the Investment Company Act of 1940 (the "Act") based on the exemption found in Section 3(c)(1) of the Act. <(4)> The Commission has recognized that "some discounts [on Regulation S shares] may well be warranted in order to compensate for the length of the restricted period, historic volatility of the stock, financial condition of the issuer, the dilution represented by the newly issued shares, current market condition, availability of current information as to the issuer, information the issuer may have had that was disclosed to the purchaser but not otherwise disclosed to the market, or other factors." Problematic Practices Release Under Regulation S, Securities Act Release No. 7190, 60 Fed. Reg. 35663, 35664 n. 14 (June 27, 1995). ======END OF PAGE 2====== unwind its hedged positions. Shortly after the 40-day restricted period expired, the Fund would deposit the Regulation S shares in a brokerage account and begin unwinding the positions. Initially, in a number of instances, the Regulation S shares purchased overseas were used to cover the short positions. Subsequently, the positions were unwound by selling the Regulation S shares into the United States markets and purchasing shares on the United States markets to cover the short positions. The unwinding process would continue until completion, which generally took several months. The Fund participated in 90 Regulation S deals involving the common stock of 47 issuers, and it engaged in the short selling strategy with respect to some or all of the Regulation S shares purchased in 62 of these deals. The Fund generally purchased the Regulation S shares at a 15% to 20% discount to the United States market price. GFL Ultra Fund Ltd.'s trading in the securities of Zitel Corporation ("Zitel") is an example of how the strategy operated. The Fund purchased 300,000 Regulation S shares from Zitel on December 12, 1994 at a discount of approximately 15% to the freely tradeable share price. The Fund partially hedged these Regulation S shares by selling short 279,800 shares in five brokerage accounts between November 14, 1994, and January 19, 1995, in connection with this purchase of Regulation S shares. The Fund locked in a profit (the differential between the price at which the 279,800 shares were sold short net of commissions and the price at which the 279,800 Regulation S shares were purchased) of $816,430.75.<(5)> By February 7, 1995, the Fund had distributed all of its Zitel Regulation S shares into the United States markets and had closed out all of its Zitel short positions with purchases in the open market. B. Violations of Section 5 of the Securities Act The Fund violated Section 5 of the Securities Act because it sold the Regulation S securities of issuers into the United States markets without registering them and because no exemption from registration applied to the sales. Pursuant to Section 5 of the Securities Act, it is unlawful for any person to sell or offer to sell a security unless it has been registered. Scienter is not required to establish a violation of Section 5. See, e.g., Stokes v. Lokken, 644 F.2d 779, 784 (8th Cir. 1981). Certain exemptions to Section 5 registration requirements exist. Those claiming an exemption from registration have the burden of showing its application. SEC v. Murphy, 626 F.2d 633, 645 (9th Cir. 1980). The Commission has promulgated various safe harbors which provide that certain offers or sales of securities falling within the safe harbors will not violate Section 5. <(5)> The Fund's total profit on the transaction was $842,147.36. This figure is the result of the market changes during the period when the short and long positions were unwound. ======END OF PAGE 3====== Regulation S, adopted by the Commission in April 1990 in order "to clarify the extraterritorial application" of the Section 5 registration provisions, "provides generally that any offer or sale that occurs within the United States is subject to section 5 of the Securities Act and any offer or sale that occurs outside the United States is not subject to section 5."<(6)> Significantly, Regulation S does not eviscerate the statutory proscriptions of Section 5. In particular, Regulation S does not provide a safe harbor within Section 5 for sales of securities within the United States. Regulation S provides two safe harbors for specified transactions. As long as the conditions of the safe harbors are met, then the offers and sales will be deemed to be "outside the United States" and, hence, not subject to Section 5 registration requirements. The "issuer safe harbor" applies to offers and sales by issuers and others in the distribution process; and the "resale safe harbor" applies to resales by persons other than those covered by the "issuer safe harbor." Both safe harbors require that the offer and sale of the securities must be made in an "offshore transaction" and that there can be no "directed selling effort" in the United States. The "issuer safe harbor" distinguishes among three categories of securities offerings "based upon factors such as the nationality and reporting status of the issuer and the degree of U.S. market interest in the issuer's securities."<(7)> Varying procedural safeguards are imposed in each category to ensure that "the securities offered come to rest offshore."<(8)> Regulation S imposes a 40-day restricted period for "reporting issuers" during which their Regulation S shares cannot be offered or sold to U.S. persons or for the account or benefit of U.S. persons. Issuers, to ensure that the shares do not flow back to U.S. persons within the 40-day period, generally include a 40-day restricted period in the subscription agreements signed with purchasers. The Fund violated Section 5 of the Securities Act by failing to register the Regulation S securities which it sold into the United States either by covering its short positions with the Regulation S shares or by directly selling the Regulation S shares (and purchasing freely-trading stock to cover the short positions). Covering a short position is the equivalent of a "sale" for purposes of Section 5 registration requirements. See In the Matter of David M. Haber, Initial Decision (July 13, 1994) (respondent participated in a transaction that "violated Sections 5(a) and 5(c) of the Securities Act when he purchased unregistered Beres stock at <(6)> Offshore Offers and Sales, Securities Act Release No. 6863, 55 Fed. Reg. 18306 (May 2, 1990) (hereinafter "Adopting Release"). <(7)> Adopting Release at 18307. <(8)> Id. at 18313. ======END OF PAGE 4====== $1.50 per share that was used to cover short sales at $3.00 per share"), aff'd 59 S.E.C. Docket 59 (April 5, 1995). There are no exemptions or safe harbors on which the Fund is entitled to rely to avoid the registration requirements. The Fund is not entitled to rely on Regulation S because the shares were sold within the United States. Preliminary Note 6 of Regulation S provides that "[s]ecurities acquired overseas, whether or not pursuant to Regulation S, may be resold in the United States only if they are registered under the Act or an exemption from registration is available." Moreover, the other exemptions within the Securities Act are inapplicable. In particular, Section 4(1), which exempts "transactions by any person other than an issuer, underwriter, or dealer" does not apply because the Fund became a "statutory underwriter" under Section 2(11) of the Securities Act.<(9)> Section 2(11) provides: The term "underwriter" means any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security . . . . The term distribution, although not defined in the Securities Act, is considered to be synonymous with a public offering and means a distribution in which the shares flow into the trading markets in a manner such that members of the investing public might come to hold the shares.<(10)> <(9)> The Commission has made clear that "[p]ublic resales [of Regulation S securities] in the United States by persons that would be deemed underwriters under Section 2(11) of the Securities Act . . . would not be permissible without registration or an exemption from registration." See Problematic Practices Under Regulation S, Securities Act Release No. 7190, 60 Fed. Reg. 35663, 35664, n. 17 (June 27, 1995) (citations omitted). <(10)> See L. Loss & J. Seligman, Fundamentals of Securities Regulation at 248 (3rd ed. 1995) ("[T]he term distribution is more or less synonymous with the term public offering, and a sell order given to a stock exchange broker results in an offer to the highest bidder anywhere in the world, which is certainly a 'public offering.'") (emphasis in the original). See also, In the Matter of Ira Haupt & Co., 23 S.E.C. 589 (1946) ("'Distribution' is not defined in the Act. It has been held, however, to comprise 'the entire process by which in the course of a public offering the block of securities is dispersed and ultimately comes to rest in the hands of the investing public.'") (emphasis added). ======END OF PAGE 5====== The quantity of shares distributed is a significant factor in the determination of whether a distribution occurred.<(11)> Here, when the Fund either covered its short positions with the unregistered Regulation S shares or sold the unregistered Regulation S shares directly into the United States markets (and purchased freely- trading shares to cover its short positions), the shares were "distributed" because substantial numbers of shares flowed into the trading markets.<(12)> The Fund purchased the Regulation S shares from the issuer with a view towards distribution. The combination of purchasing Regulation S securities at a discount and selling short securities of the same issuer before and/or during the restricted period essentially locked in a profit of the differential between the price at which the shares were sold short and the discounted price at which the Regulation S shares were purchased. In order to realize this profit, the positions needed to be unwound, which resulted in the distribution of the unregistered Regulation S shares. The fact that essentially all the Regulation S shares were distributed several months after the purchase of those shares is evidence that the shares were purchased with a view to distribution.<(13)> The Commission has indicated its concern about the type of trading strategy in which the Fund engaged in its release entitled "Problematic <(11)> See, e.g., United States vs. Wolfson, 405 F.2d 779, 783 (2d Cir. 1968), cert. denied, 394 U.S. 946 (1969) ("[T]here can be no doubt that appellants' sale of over 633,000 shares (25% of the outstanding shares of Continental and more than 55% of their own holdings), was a distribution rather than an ordinary brokerage transaction."); Ira Haupt & Co., supra (a distribution is equated with "transactions by which substantial quantities of securities are disposed of to the public"). <(12)> In connection with its purchases of Zitel common stock, for example, the Fund purchased two-thirds of the Regulation S shares offered by Zitel in December 1994 and subsequently sold 100% of its position in the U.S. markets by February 1995. The Fund's sale of the Zitel Regulation S shares accounted for approximately 4.2% of Zitel's outstanding shares. <(13)> Section 5 may be violated if the trier-of-fact concludes that securities were acquired by a person with a view to distribution and where no exemption from registration is available. To violate Section 5, it is not necessary for the person acquiring such securities to have a specific intent to violate the securities laws. ======END OF PAGE 6====== Practices Under Regulation S."<(14)> The "Problematic Practices" release did not modify the scope of Regulation S. Therefore, although the Commission issued the release after the Fund had ceased purchasing Regulation S securities, the conduct described in this Order violated Section 5 whenever it occurred. The intent of Regulation S was to provide a safe harbor from the registration requirements of Section 5 where the securities offered came to rest overseas. The trading pattern of short selling in the United States in connection with purchasing in a Regulation S offering, which essentially locks in a profit, and the subsequent unwinding of those positions through sales in the United States runs counter to the goals of Regulation S. Such a pattern ensures that the Regulation S shares will flow back into the United States in a relatively short period of time. Based on the foregoing, the Commission finds that the Fund committed violations of Section 5 of the Securities Act when it sold unregistered Regulation S shares in the United States. IV. ORDER Accordingly, IT IS HEREBY ORDERED, pursuant to Section 8A of the Securities Act, that GFL Ultra Fund Ltd. cease and desist from committing any violation, and any future violation, of Section 5 of the Securities Act. By the Commission (Commissioner Wallman dissenting -- see attached). Jonathan G. Katz Secretary <(14)> Securities Act Release No. 7190, 60 Fed. Reg. 35663 (June 27, 1995). One "problematic practice" noted by the Commission is "short selling . . . where purchasers transfer the benefits and burdens of ownership back to the United States market during the restricted period [specified in Regulation S]." Id. at 35664. In October 1996, the Commission adopted reporting requirements concerning the issuance of Regulation S equity securities by U.S reporting companies. Periodic Reporting of Unregistered Equity Sales, Exchange Act Release No. 37801, 61 Fed. Reg. 54506 (October 10, 1996). In February 1997, the Commission published for comment proposed amendments to the Regulation S safe harbor procedures. Offshore Offers and Sales, Securities Act Release No. 7392 (February 20, 1997). Neither the October 1996 release nor February 1997 release affect the Commission's finding that the Fund's conduct violated Section 5. ======END OF PAGE 7====== --------------------------------------------------------------------------------- DISSENT OF COMMISSIONER STEVEN M.H. WALLMAN In the Matter of GFL Ultra Fund Ltd. Preliminary Note 6 to Regulation S states "[s]ecurities acquired overseas, whether or not pursuant to Regulation S, may be resold in the United States only if they are registered under the Act or an exemption from registration is available." After the adoption of Regulation S in 1990, confusion existed outside of the Commission as to when purchasers of securities placed offshore pursuant to Regulation S were permitted under the U.S. federal securities laws to resell such securities back into the United States markets. There also was (and still is) confusion regarding whether hedging (such as short sales) by purchasers of Regulation S securities may take place in the U.S. markets within the restricted period. Some members of the bar interpreted the 40-day or one-year restricted periods to be the equivalent of a holding period analogous to the Rule 144 safe harbor under the Securities Act. 1/ These legal practitioners advised their clients that the expiration of the restricted period provided a safe harbor for U.S. resales by purchasers of Regulation S securities, and that no further analysis as to whether the seller could be deemed a "statutory underwriter" within the meaning of section 2(11) of the Securities Act was necessary. As to hedging, since Regulation S itself was silent on the subject, some members of the bar, including counsel for Ultra, looked to Rule 144 interpretations for guidance on whether hedging could take place within the restricted period. Since 1990, there have been repeated calls for guidance from the Commission on these points. In addition, over time, the Commission and its staff became aware of a multitude of abusive practices where Regulation S was nominally being used to conduct unregistered securities offerings in the United States. In the absence of clearcut guidance from the Commission, some entities, such as Ultra, chose to take aggressive advantage of the business opportunities presented. _______________________________ /1 Under Rule 144, any affiliate or other person who sells restricted securities shall be deemed not to be engaged in a distribution of such securities and therefore not to be an underwriter within the meaning of section 2(11) of the Securities Act if all of the conditions of the rule, including the satisfaction of the holding period, are met. ==========START OF PAGE 2====== Despite the confusion and uncertainty, it wasn't until 1994 that the Commission and its staff began informally making statements about problems in the Regulation S area. The Commission failed to make any formal pronouncements regarding Regulation S until the issuance of the Problematic Practices release in June 1995. 2/ Finally, in February of this year, the Commission proposed changes to Regulation S in order to stop the abusive practices. 3 / By the time the latter two releases were issued, Ultra already had ceased its trading strategy involving Regulation S securities. In the February release, the Commission clearly stated that the restricted period under Regulation S was never intended to be analogous to a holding period under Rule 144, that it did not provide a safe harbor for U.S. resales by purchasers, and that resales into the United States without registration must be evaluated under a "statutory underwriter" analysis regardless of the issuer's compliance with Regulation S. The Commission also proposed changes to both Regulation S and Rule 144 to deem equity securities of U.S. issuers placed offshore pursuant to Regulation S as restricted securities within the meaning of Rule 144. /4 If adopted, offshore purchasers wishing to resell these securities into the U.S. markets must either register the resale, comply with Rule 144 (including the one year holding period), or find some other exemption from registration. These changes should provide long-needed clarity and should fix the problem. With regard to hedging, in the Problematic Practices release, the Commission raised concerns about hedging in the U.S. markets by purchasers of Regulation S securities during the restricted period. In both the February release and its companion Rule 144 proposing release, /5 the Commission continued _______________________________ /2 Problematic Practices Under Regulation S, Securities Act Release No. 7190 (June 27, 1995). /3 Offshore Offers and Sales, Securities Act Release No. 7392 (February 20, 1997). / 4 Equity securities of foreign issuers where the principal market for those equity securities is in the United States also will be deemed restricted securities under the proposals. /5 Revision of Rule 144, Rule 145 and Form 144, Securities Act Release No. 7391 (February 20, 1997). ==========START OF PAGE 3====== to raise questions and concerns regarding hedging by purchasers of unregistered securities -- including the Section 5 ramifications of hedging. While continuing to seek comment, the Commission has not yet made any definitive statements regarding what forms of hedging are or are not permissible with regard to unregistered securities. Given the confusion prior to June 1995 and February 1997 in legal interpretations, the relative lack of clearcut guidance from the Commission or its staff during the period of time that Ultra engaged in its trading strategy, the partial regulatory solution already put on the table in form of the proposed changes to Regulation S, and the continuing uncertainty regarding the impact of hedging, I do not think it is appropriate to bring an "after the fact" enforcement case at this time, regardless of the fact that the party is settling. In addition, to initiate proceedings against, and accept a settlement from, only Ultra -- an entity in the process of winding up its activities -- and not charge its related entity (who also engaged in the same trading strategy prior to Ultra), or any officer or director, or even the lawyers here, merely highlights the legal confusion surrounding the case. My views should not be construed, however, as a statement that Ultra's actions were appropriate or in compliance with the federal securities laws -- just that enforcement action in this instance is not appropriate. Therefore, I respectfully dissent.