SECURITIES AND EXCHANGE COMMISSION ADVISORY COMMITTEE ON THE CAPITAL FORMATION AND REGULATORY PROCESSES July 24, 1996 Chairman Arthur Levitt Commissioner Norman S. Johnson Commissioner Isaac C. Hunt Securities and Exchange Commission Washington, DC 20549 Dear Mr. Chairman and Commissioners: The Commission's Advisory Committee on the Capital Formation and Regulatory Processes is pleased to transmit its final report to the Commission. The Committee unanimously recommends that the Commission act promptly both to strengthen existing investor safeguards and to reduce the costs of corporate capital formation in the United States by establishing a company-based registration system. Company registration is the logical culmination of a progression over the past three decades -- a progression encouraged by Congress, investors, industry and others -- away from the transaction-based framework for the registration of securities offerings. On numerous occasions in the past, the Commission, just as it has done now by creating this Committee, has recognized the need for reforms in the transaction-based system. In 1982, for example, the Commission took a major step towards the goal of company registration by establishing its precursor -- the integrated disclosure system for the primary offering and secondary trading markets, and the concurrent adoption of the streamlined shelf registration procedure. Consistent with the view of a decade and a half ago, the Committee today believes that the transactional concepts still underlying the current scheme continue to impose unnecessary costs and restrictions on issuer access to capital. Perhaps more importantly, in many instances the transactional system also serves as an impediment to full and timely disclosure to investors and the markets, and the realization of the full potential for investor protection provided by the Securities Act. After much research, study and debate, the Committee has concluded that the significant changes in the securities markets over the past sixty years, which have accelerated in the last dozen or so, continue to strain the remnants of the current transactional registration scheme. More specifically, as detailed in the Committee's report, the Committee has identified a variety of regulatory uncertainties, complexities and anomalies, many of which stem from efforts to adapt the Securities Act's registration and prospectus delivery provisions to current market developments. Over time, the continuation of these changes will reduce the current scheme s ability to provide the highest level of essential investor protections. Moreover, certain innovations brought about by, among other factors, technology and the globalization of our markets, while benefiting issuers, have not always produced meaningful countervailing benefits for investors in either the primary offering or secondary trading markets. In fact, in certain cases, these innovations have had the unintended consequence of possibly weakening available investor protections. In addition, they have not addressed the concerns of other market participants who have legal obligations created under a scheme crafted in the 1930s, but whose ability to execute their duties has come under stress in the financing environment of the 1990s. Accordingly, the Committee commends Chairman Levitt and the Commission for charging the Committee with the responsibility to evaluate the continuing efficacy of the present scheme governing corporate capital formation, and to consider and, if warranted, recommend an alternative approach. The Committee recognizes that streamlining can be accomplished at the expense of, or at least without increasing, investor protection. Consistent with the principles of Chairman Levitt s leadership and the Commission s historical approach, the Committee refused to proceed in that direction. It assumed the mandate of crafting a system that would both increase investor protection and reduce regulatory burdens. Under the new approach, reporting companies will benefit from an offering process that essentially converts the current, stop-and-go shelf registration system into a continuous, pay-as- you-go registration process. Under a full company registration system, the one-time registration of eligible companies generally would encompass all securities that they or their affiliates might offer or sell thereafter. Issuers and investors will both benefit from this fundamental conceptual change that will eliminate artificial distinctions among the markets for the issuer's securities and the restrictions on the resale of those securities based upon the nature of the transaction in which the security was initially sold. In addition, investors benefit from an appropriately expanded reach of the Securities Act s liability protections to cover more transactions, including private placements and the flowback of offshore offerings, and more disclosures, than under the current system. Importantly, an integral part of the company registration system is improvements in disclosure practices by registered companies. Increased attention focused on the periodic reports provided to the markets makes sense. Investors rely on those reports in deciding whether to buy securities pursuant to an offering by a public company or any of its affiliates. They also rely on those reports in deciding whether to buy or sell that company's securities in the secondary trading markets. The secondary trading markets have grown so substantially, and so dwarf the primary markets, that a disclosure system that relies on high quality disclosures only when a company episodically, if ever, goes to market disserves the investing public. Moreover, in order for a streamlined offering process that relies on the existing periodic reports to work without harming investor interests, the system must ensure the highest level of integrity for those periodic reports. Any streamlining without improving the current disclosure process should not be acceptable. Consequently, the company registration model includes specific reforms tailored to enhance the accuracy and reliability of information, and the timeliness of the information, furnished by registered companies to investors and other participants in the securities markets. The company registration model also reinforces investor protection by incorporating measures that enhance the monitoring functions of underwriters, outside directors and auditors. All these reforms are loyal to the central premise that the benefits and protections of the regulatory process, heretofore triggered by the infrequent and unpredictable occasion of a public offering of securities, should operate on a continuous basis for the benefit of all investors in the company's securities. The Committee recommends that the Commission pursue as its ultimate goal the implementation of a full company registration model that eliminates completely the need to register securities offerings, thereby replacing the current transactional registration requirements and exemptions for all reporting companies. The Committee also recommends, however, that the system be initiated through a voluntary "pilot" program open only to larger, more seasoned, companies. The Committee believes that such a pilot will provide a meaningful market test of the advantages of this model and will provide greater flexibility for any experimentation or adjustment the Commission might deem necessary or appropriate. The pilot program should provide the foundation for deciding what legislative and regulatory modifications, if any, would be appropriate to complete the transition to a company registration system. In closing, the Committee's members wish to thank Chairman Levitt and the Commission for the opportunity and the privilege to serve on the Committee and to participate in these important reforms. The Committee strongly believes that this new system will provide companies and their investors with a regulatory scheme to meet their needs in the new century. At each of the times in the past when the Commission considered bold action that would both improve investor protection and streamline the capital formation process, this country's markets were the largest, the most liquid, the deepest and the most honest. Each time regulatory innovations were in fact adopted that combined both investor protection and streamlining, the markets became even better. The Commission has the opportunity to do that again here. Each member of the Committee looks forward to the Commission's progress in considering the Committee's recommendations, and remains willing to provide any additional assistance in this regard. Respectfully submitted on behalf of the Committee, The Honorable Steven M.H. Wallman Committee Chairman Members of the Committee: Professor John C. Coffee, Jr. The Honorable Barber B. Conable, Jr. Robert K. Elliott Edward F. Greene Dr. George N. Hatsopolous A. Bart Holaday Paul Kolton Roland M. Machold Dr. Burton G. Malkiel Claudine Malone Charles Miller Karen M. O'Brien Lawrence W. Sonsini TABLE OF CONTENTS I. INTRODUCTION AND SUMMARY A. Findings and Recommendations of the Committee. . . . . . . . . . B. The Work of the Committee and Structure of the Report. . . . . . . II. RECOMMENDATIONS OF THE ADVISORY COMMITTEE A. Reasons for the Recommendations and Anticipated Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1. General Statement of Committee's Recommendation to Shift From a Transactional Registration System to a Company Registration System. . . . . . . . . . . . . . . . . . . . . . . 2. Identified Problems of the Current Transactional System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3. Company Registration as the Logical Conclusion of Evolutionary Change in the Regulatory Process . . . . . . . . . . . . . . . . 4. The Benefits of the Company Registration System as Compared to the Current Transactional Regulatory System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B. Key Elements of the Recommendations 1. The Offering Process . . . . . . . . . . . . . . . . . . . . . . . 2. Prospectus Delivery Requirement. . . . . . . . . . . . . . . . . . 3. Scope. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4. Disclosure Enhancements. . . . . . . . . . . . . . . . . . . . . . 5. Liability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6. Due Diligence. . . . . . . . . . . . . . . . . . . . . . . . . . . 7. Disclosure Committee . . . . . . . . . . . . . . . . . . . . . . . III. CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . IV. SEPARATE STATEMENT OF JOHN C. COFFEE, JR., EDWARD F. GREENE, AND LAWRENCE W. SONSINI. . . . . . . . . . . . . . . . . . . . . . . . . APPENDIX A: THE IMPACT OF THE CURRENT REGULATORY SYSTEM ON INVESTOR PROTECTION AND CAPITAL FORMATION I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . II. Direct and Indirect Costs and Uncertainties Resulting From the Registration Process for Public Offerings . . . . . . . . . . A. Costs of Registration - The Offering Process . . . . . . . B. Indirect Costs Associated with the Current Regulatory Scheme III. Changes in the Markets and Offering Processes, and the Effect on Investor Protection. . . . . . . . . . . . . . . . . . . . . . . . A. Attractiveness of Public, Private and Offshore Markets . . . B. Blurring of Distinctions Between Public, Private and Offshore Markets . . . . . . . . . . . . . . . . . . . . . . C. Growth of Secondary Markets and Changes in Offering Techniques . . . . . . . . . . . . . . . . . . . . . . . . . D. Changes in Gatekeeper Role . . . . . . . . . . . . . . . . . Addendums to Appendix A APPENDIX B: ESSENTIAL ELEMENTS OF THE COMPANY REGISTRATION SYSTEM I. Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . A. Disclosure and Prospectus Delivery Under the Company Registration System. . . . . . . . . . . . . . . . . . . . B. Role of the SEC and Other Gatekeepers. . . . . . . . . . . . II. Company Eligibility. . . . . . . . . . . . . . . . . . . . . . . . III. Transactions Covered . . . . . . . . . . . . . . . . . . . . . . . A. Affiliate and Underwriter Resales. . . . . . . . . . . . . . B. Exclusions . . . . . . . . . . . . . . . . . . . . . . . . . C. Offshore Offerings . . . . . . . . . . . . . . . . . . . . . D. Preservation of Transactional Exemptions . . . . . . . . . . E. Limited Placements . . . . . . . . . . . . . . . . . . . . . IV. Disclosure Enhancements Under the Recommended Company Registration Model . . . . . . . . . . . . . . . . . . . . . . . . A. Mandatory Disclosure Enhancements. . . . . . . . . . . . . . B. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . V. Liability and Due Diligence Under Company Registration . . . . . . A. Liability Under Company Registration . . . . . . . . . . . . B. Due Diligence Under Company Registration . . . . . . . . . . C. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . Addendum to Appendix B -- Comparison of Company Registration and Shelf Offering System ==========================================START OF PAGE 1====== COMMITTEE MEMBERS The Honorable Steven M.H. Wallman, Committee Chairman SEC Commissioner; former partner, Covington & Burling Professor John C. Coffee, Jr. Adolf A. Berle Professor of Law, Columbia University Law School The Honorable Barber B. Conable, Jr. Corporate director; former President, World Bank; former member, U.S. House of Representatives; and former New York Stock Exchange director Robert K. Elliott Partner, KPMG Peat Marwick LLP; Chair, AICPA Special Committee on Assurance Services, and Member, AICPA's Board of Directors and Governing Council Edward F. Greene Partner, Cleary, Gottlieb, Steen & Hamilton; former SEC General Counsel; and former Director, SEC Division of Corporation Finance Dr. George N. Hatsopoulos Chairman of the Board and President, Thermo Electron Corporation; and former Chairman, Federal Reserve Bank of Boston A. Bart Holaday Managing Partner, Private Markets Group and Member of the Board of Directors, Brinson Partners, Inc.; and member of the board, National Venture Capital Association Paul Kolton Corporate and fund director; former President and Chairman of the American Stock Exchange; former Chairman, Financial Accounting Standards Board's Advisory Council Roland M. Machold Director, New Jersey Division of Investment; former Vice President, Morgan Stanley & Co. Dr. Burton G. Malkiel Professor of Economics, Princeton University and corporate and fund director; former Dean, Yale School of Management; former member, President's Council of Economic Advisers. Claudine B. Malone President of Financial & Management Consulting, Inc., and corporate director; former Professor, Harvard Graduate School of Business Administration Charles Miller ==========================================START OF PAGE 2====== Chairman, Medallion Investment Management Company and Meridian Advisors, Ltd.; corporate director; former Chief Investment Officer, Transamerica Asset Management Group Karen M. O'Brien General Counsel, North American Securities Administrators Association Lawrence W. Sonsini Partner, Wilson, Sonsini, Goodrich & Rosati; corporate director COMMITTEE STAFF David A. Sirignano, Committee Staff Director Associate Director Division of Corporation Finance Dr. Robert Comment Deputy Chief Economist Office of Economic Analysis Catherine T. Dixon Chief, Office of Mergers and Acquisitions Division of Corporation Finance Meridith Mitchell Assistant General Counsel Office of the General Counsel Luise M. Welby Special Counsel Office of International Corporate Finance Division of Corporation Finance. ==========================================START OF PAGE i====== I. INTRODUCTION AND SUMMARY A. Findings and Recommendations of the Committee In February 1995, the Securities and Exchange Commission (the "Commission" or "SEC") established the Advisory Committee on the Capital Formation and Regulatory Processes (the "Committee"). Commissioner Steven M.H. Wallman was appointed by SEC Chairman Arthur Levitt as the Committee's Chairman. The Committee was authorized to advise the Commission on, among other things, the current regulatory process and the disclosure and reporting requirements relating to public offerings of securities, as well as secondary market trading, and to identify and develop means to minimize the costs imposed by existing regulatory programs.-[1]- The Committee determined to focus specifically on the regulatory framework for securities offerings and continuing disclosure by corporate issuers. Early in its deliberations, the Committee concluded that the current procedures under the Securities Act of 1933 (the "Securities Act")-[2]- are well suited for companies that are engaging in an initial public offering, i.e., a transaction in which a company is publicly offering its securities for the first time. The Committee determined, however, that the capital-raising activities of ---------FOOTNOTES---------- -[1]- Copies of the Committee's original Charter and renewal Charter are attached in Appendix D. -[2]- 15 U.S.C. 77a et seq. ==========================================START OF PAGE ii====== companies that have already offered their securities to the public and are currently filing periodic reports with the Commission pursuant to the Securities Exchange Act of 1934 (the "Exchange Act")-[3]- have changed dramatically and fundamentally over the last half century. Consequently, the Committee primarily focused its attention on identifying issues and crafting solutions related to those activities. The Committee initially identified certain aspects of the current transactional registration approach of the Securities Act that, at least as applied to reporting companies, may adversely affect investor protection and the capital formation process. The Committee then explored alternative regulatory strategies that would: (i) enhance investor protection by extending and reinforcing the protections of the Securities Act; (ii) improve the efficiency of access by such companies to the U.S. capital markets; (iii) eliminate unnecessary regulatory costs and uncertainties for issuers; and (iv) enhance the quality and integrity of disclosures provided to investors in both the primary offering and secondary trading markets.-[4]- The Committee generally concluded that, in order to achieve these ---------FOOTNOTES---------- -[3]- 15 U.S.C. 78a et seq. -[4]- The Committee staff also examined foreign regulatory schemes relating to public offerings of securities for guidance with respect to possible alternative regulatory approaches, particularly with respect to offerings by seasoned issuers. See Documents for Advisory Committee Meeting, June 15, 1995, Tab F (the Committee staff's study of certain foreign regulatory schemes). ==========================================START OF PAGE iii====== goals, the focus of the regulatory process in the post-initial public offering context should be shifted from registering transactions to registering companies, with a corresponding emphasis on better ensuring the accuracy and integrity of continuing disclosures. As a consequence of this conceptual shift, once a company is registered and filing the required public reports, all the securities that the company or its affiliates sell thereafter would be deemed registered for purposes of the Securities Act, investors would be more fully protected in more transactions, and the issuer would be able to offer and sell its securities without any regulatory delay in virtually all cases. The Committee next developed a package of concepts -- under the label "company registration" -- to accomplish this shift in regulatory focus. At the request of the Committee, the Committee staff created a working "Term Sheet" describing possible company registration models to be implemented on an experimental or "pilot" basis, which the Committee used as an evolving framework for consideration and discussions at Committee meetings.-[5]- The model includes measures designed both to streamline the offering and disclosure processes, and to improve the timeliness, quality, reliability and integrity of information provided to investors and other participants in the securities ---------FOOTNOTES---------- -[5]- The most recent Term Sheet outlining a model for a pilot program to test the company registration concept is attached as Appendix C to this Report. ==========================================START OF PAGE iv====== markets. Based upon Committee deliberations, as well as Committee and staff consultations with representatives of the investor, issuer, underwriter, legal, accounting and academic communities, the Committee concluded that the proposed company registration system would reduce substantially unnecessary regulatory costs and burdens for issuers while enhancing investor protection. As discussed more fully in the balance of this Report, the Committee determined that a pilot company registration program would be the most appropriate way to begin the transition. The pilot would be available initially only to issuers that meet certain criteria, such as having a specified minimum public float and reporting history. Because these issuers generally are more sophisticated with respect to financial reporting and other disclosure requirements and are more widely followed by the markets, the Committee concluded that permitting these types of issuers to opt into the pilot program would provide the best test of the advantages of the company registration system as compared to the current system. If the pilot is successful, the Committee believes that the Commission should extend the benefits of company registration, perhaps with additional conditions, to smaller public companies and their investors as soon as possible. The streamlining of the offering process will result from the adoption of a new registration procedure under which the company would register to enter into the system (on a new Form C- 1 registration statement). Thereafter, each issuance by the ==========================================START OF PAGE v====== registered company of its securities would be deemed registered under the Securities Act, including securities issued in acquisitions and securities initially sold offshore that flow back into the United States, with all the protections and remedies that currently adhere to a registered transaction. A registration fee would be paid to the Commission at the time of each sale of securities, rather than at the time of filing of the Form C-1 (thereby creating a "pay-as-you-go" system). As a result, the current limitations of the shelf registration system on the amount of securities that could be registered would be eliminated, as would the need to file a new registration statement to register additional securities. This process also would eliminate the uncertainties and delay in the offering process resulting from the potential for Commission staff review prior to a registration statement being declared effective. Such uncertainty and delay has already been eliminated in the context of takedowns from an already effective shelf registration statement, but not with respect to the initial effectiveness of the shelf registration statement. Under company registration, the nature and amount of information about the company and its securities required to be on file with the Commission at the time of sale would be at least as extensive as that now required under the current Securities Act registration forms. Provided all mandated information has been disclosed to the markets, issuers in routine transactions would be permitted to tailor the disclosure physically delivered ==========================================START OF PAGE vi====== to investors in a prospectus as necessary to meet the informational demands of investors in light of the nature of the transaction, as assessed by the issuer and underwriter in marketing the securities. Consequently, the information provided to investors should be both more readable (in plainer English) and more useful (because it is tailored to the investors' needs). Moreover, under a "full" company registration system where all securities are registered, a reduction in the scope of the resale restrictions applicable to affiliates is possible and desirable because subjecting these holders to resale restrictions would serve no purpose since all the securities are already registered. As a result, most directors and officers will no longer be subject to resale restrictions. The investor protection improvements of the company registration system will deliver benefits both at the time of the offering and on an ongoing basis. In most equity offerings, information regarding the specific transaction and any material developments will be filed with the Commission, and therefore made available to all investors and the markets, no later than the date of first sale (material developments will have to be on file in sufficient time for the market to absorb the information before the sale is made), rather than as late as two days after the delivery of the prospectus as permitted under the current shelf registration system. This reform will serve a number of beneficial purposes. First, it ensures that the market receives timely notice of material developments, thereby providing the ==========================================START OF PAGE vii====== market sufficient opportunity to react to the information prior to investors making an investment decision. Second, it will assist underwriters and others with due diligence responsibilities to focus on the information important to the offering and help ensure that it is fully and accurately disclosed. Third, it will extend full coverage of the statutory liability provisions to this important information. In addition, in those large offerings where issuers will be required under the model to deliver a formal prospectus, the prospectus must be delivered to a potential investor in time to inform the investment decision. Under current procedures, the prospectus can be delivered with the confirmation, well after an investor has already made an investment decision. Various measures designed to improve the quality and integrity of a registered company's disclosure on an ongoing basis are part of the recommended company registration system. These measures include improved procedures to focus the attention of management and the board of directors on the periodic and other reports prepared and filed by the company, and to provide for more timely disclosure of material developments. For the first time, risk factor disclosure will be provided to investors in the secondary trading markets through the company's annual report on Form 10-K filed with the Commission. In addition, the company registration system will create incentives for the reordering and rationalization of "information monitoring" or "gatekeeping" functions to provide greater oversight of the ======================================START OF PAGE viii====== issuer's disclosures on an ongoing basis. The system does so by, among other things, specifying additional factors that may be taken into consideration in satisfying the due diligence and reasonable care defenses of certain gatekeepers or monitors under Sections 11 and 12(a)(2) of the Securities Act. By enhancing the quality and integrity of disclosure and thereby reducing the likelihood of material misstatements and omissions by the issuer and others engaged in a public offering, the model also should operate, as a practical matter, to decrease the liability exposure of these parties. In connection with its deliberations on company registration, the Committee also examined the concept of encouraging a company's board of directors to adopt a board "disclosure committee" (which could be the audit committee). This concept has as its goal enhancing the reliability and integrity of an issuer's public disclosures, by promoting better and more intensive due diligence on the part of outside directors on an ongoing basis. This separate recommendation of the Committee, which could be effectuated regardless of whether company registration is adopted (and, conversely, company registration could be adopted regardless of whether the disclosure committee concept is embraced), also is discussed in this Report. B. The Work of the Committee and Structure of the Report The Committee held eight public meetings. The Committee and its staff also met with numerous groups and individuals concerned ==========================================START OF PAGE ix====== with or affected by the Commission's regulation of the capital formation process. The Committee wishes to acknowledge with deep appreciation the thoughtful comments and insights provided by these groups and individuals. The letters and articles submitted by commenters for the benefit of the Committee are available from the SEC Public Reference Room, File No. 265-20. Except with respect to certain recommendations to improve the quality and integrity of periodic reporting under the Exchange Act, the Committee determined not to address specific line-item requirements prescribing the content and manner of presentation of disclosure documents filed with the Commission. An internal Commission task force, known as the Task Force on Disclosure Simplification, has reviewed these requirements, and recently published a report recommending that the Commission eliminate 91 rules and 22 forms, and modify dozens of others.-[6]- Separately, the Commission also initiated rulemaking addressing several issues raised by Committee members in the course of the Committee's deliberations.-[7]- The ---------FOOTNOTES---------- -[6]- See Report of the Task Force on Disclosure Simplification to the Securities and Exchange Commission (March 5, 1996). -[7]- For example, improving the safe-harbor for forward-looking statements was a significant concern of some members of the Committee, a matter which already was under consideration by both the Commission and Congress during the deliberations on the Private Securities Litigation Reform Act of 1995, enacted in late 1995 (Pub. L. No. 104-67 (December 22, 1995)); see also Safe Harbor For Forward-Looking Statements, Securities Act Rel. 7101 (October 13, 1994)[59 FR 52723 (October 19, (continued...) ==========================================START OF PAGE x====== Committee also determined at the outset of its deliberations to focus on issues regarding the application of the Securities Act to companies that are reporting under the Exchange Act. The Commission already was pursuing many issues affecting non- reporting companies that access the securities markets for capital pursuant to various Securities Act exemptions.-[8]- Consequently, these specific issues and policies are not addressed in this Report. The Committee's recommendations are presented in two main parts in this Report. Section IIA of the Report contains a ---------FOOTNOTES---------- -[7]-(...continued) 1994)]. Various Committee members also were critical of the Commission's rules under the Securities Act requiring the disclosure of financial and other business information about material acquisitions or dispositions. The Commission has now proposed conforming those rules under the Securities Act to the requirements under the Exchange Act. See Streamlining Disclosure Requirements Relating to Significant Business Acquisitions and Requiring Quarterly Reporting of Unregistered Equity Sales, Securities Act Rel. 7189 (June 27, 1995)[60 FR 35656 (July 10, 1995)]. -[8]- For example, numerous Committee members suggested that the Commission seek ways to facilitate capital formation by small businesses. In June 1995, the Commission issued a proposal regarding a "test the waters" provision with respect to initial public offerings to allow private companies contemplating a public offering to ascertain whether their securities are marketable before preparing expensive registration documentation. See Solicitations of Interest Prior to an Initial Public Offering, Securities Act Rel. 7188 (June 27, 1995)[60 FR 35648 (July 10, 1995)]; see also the recently adopted Exemption for Certain California Limited Issues, Securities Act Rel. 7285 (May 1, 1996)[61 FR 21356 (May 9, 1996)]. ==========================================START OF PAGE xi====== general discussion of the Committee's recommendation that the Commission shift its regulatory focus from the registration of securities transactions to the registration of companies, and the reasoning underlying that recommendation. Appendix A to the Report provides more detailed support for the Committee's recommendations. It also includes data and empirical research on the effects of the current regulatory scheme governing public offerings on investor protection and capital formation in the U.S. markets. In addition, Appendix A discusses the various costs and uncertainties of the current transactional process for Exchange Act reporting companies. It reviews the increasingly complex and technical regulatory concepts that have become necessary to protect the current transaction-based paradigm in light of significant shifts in investor demographics, market structure and communications technology, and describes how these concepts may no longer be achieving their intended goals of protecting investors. Appendix A concludes with a discussion of the blurring among and between the public, private and offshore markets, and the fundamental changes in both the composition of these markets and their participants since the enactment of the federal securities laws more than sixty years ago. Section IIB of the Report includes a summary description of the recommended terms of the company registration system and the suggested pilot project, as well as the Disclosure Committee proposal. Appendix B to the Report, in turn, describes in more detail each of the essential elements of the company registration ==========================================START OF PAGE xii====== system -- with respect both to the recommended pilot and full company registration system -- and explores further the support, reasoning and rationale underlying each recommended element. Finally, a concurring statement by Committee members John C. Coffee, Jr., Edward F. Greene, and Lawrence W. Sonsini is set forth in Section IV of the Report. ======================================START OF PAGE xiii====== COMPANY REGISTRATION PILOT AT A GLANCE Essential Elements A. Offering Process -- Further liberalization of shelf registration process; pay upon issuance fee system; no limit as to number or dollar amount of securities registered; available for acquisitions; prospectus delivery simplified. B. Disclosure Enhancements -- Improve level and reliability of information provided to primary and secondary trading markets through (i) measures such as senior management review of disclosure and management reports on procedures for disclosure preparation; (ii) more current disclosure of significant developments; and (iii) earlier filing of transactional information than under current requirements. C. Enhanced Monitor or Gatekeeper Functions -- Maintain current liability scheme while providing additional guidance regarding due diligence obligation to emphasize roles of parties involved with the company on a continuous basis and to facilitate greater involvement by certain "gatekeepers" or "monitors" in disclosure oversight. ==========================================START OF PAGE xiv====== D. Enhanced Investor Protections -- In addition to B and C above, extend statutory liability to documents and transactions that currently lack such protections. E. Scope -- Voluntary system available to seasoned issuers during initial pilot; covers all offerings of nonexempt securities, eliminating need for the concept of "restricted" securities and limiting application of resale restrictions to a narrower subset of affiliates, and permitting narrower application of the statutory underwriter concept; issuers can elect less comprehensive pilot system preserving exemption for private placements, but then apply current restrictions on resales of privately placed securities, including current broader application of affiliate and statutory underwriter requirements. Goals, Benefits, and Effects A. Eliminate unnecessary regulatory costs and uncertainties that impede access to capital; instead, market considerations, rather than regulatory concerns, will govern timing of offering; eliminate mandatory waiting period and potential for prior SEC staff review of routine transactions that now add cost and uncertainty. ==========================================START OF PAGE xv====== Greater flexibility to go to market more often in lesser amounts in light of lower transaction costs and less delay and uncertainty -- will facilitate adoption of "just-in-time capital" techniques; alleviate market overhang effect that may still result from placing equity on a universal shelf; elimination of a separate registration requirement for acquisitions. Greater flexibility in defining nature of marketing efforts: timing and content of prospectus disclosure delivered to investors driven primarily by informational needs of investors, rather than need to prepare and deliver after- the-fact compliance documents; more flexibility in negotiating transactions because regulatory constraints significantly diminished. B. Reduce complexities and pricing discounts arising from the need to distinguish between public and private, domestic and offshore, and issuer and non-issuer transactions, including concerns regarding gun-jumping, integration, general solicitation, restricted securities, and other constructs developed over the years to maintain the separation of the public and private markets. C. Maintain and enhance the protection of investors in the primary and secondary trading markets with disclosure ==========================================START OF PAGE xvi====== enhancements resulting in better due diligence practices and heightened level and reliability of corporate reporting; statutory remedies extended to more disclosure and to a broader class of transactions. D. Eliminate affiliate-type resale requirements for most officers and directors; provide additional guidance as to what constitutes "reasonable investigation" and "reasonable care" in context of the integrated disclosure and streamlined offering process. II. RECOMMENDATIONS OF THE ADVISORY COMMITTEE A. Reasons for the Recommendations and Anticipated Benefits 1. General Statement of Committee's Recommendation to Shift From a Transactional Registration System to a Company Registration System In the Committee's view, the U.S. capital markets are deep, liquid, efficient and reliable and, overall, the U.S. regulatory system for securities offerings works relatively well. While concluding that the system is not broken, the Committee believes that there is room for improvement. In the words of one member, "some fixing would make the system work even better."-[1]- The fact that the primary equity markets have not demonstrated any long-term upward trend as a source of capital since 1933, despite the fact that real Gross Domestic Product has tripled during that period,-[2]- amply justifies an inquiry into possible regulatory inefficiencies. In this regard, the Committee identified various uncertainties, complexities and anomalies in the current transactional system that unduly burden capital formation for issuers without providing significant ---------FOOTNOTES---------- -[1]- Transcript of May 8, 1995 Advisory Committee meeting at 155 (statement of Dr. Burton Malkiel). Indeed, as noted by one commenter, the "strength of our current capital markets serves as a testament to the existing securities legislation, related regulations, and interpretations." Documents for Advisory Committee Meeting, May 8, 1995, Tab I (Letter dated April 10, 1995 from Michael A. Conway, Senior Partner, KPMG Peat Marwick LLP to the Committee). -[2]- See Figures 1 and 2 in the Addendum to Appendix A of the Report. ==========================================START OF PAGE 2====== offsetting benefits to investors, and other anomalies that operate to deny needed investor protections. Although recognizing the past and ongoing efforts of the Commission to address these concerns through incremental regulatory reform, the Committee strongly believes that the time has come for a fundamental conceptual change in the scheme of regulation governing public offerings.-[3]- The Committee views a shift to company registration as the most logical culmination of the evolving recognition over the past thirty years by the Commission, commentators, the courts and market participants, of the need for reform. Specifically, it has long been recognized that a disclosure scheme dependent on infrequent, unpredictable and episodic offering transactions to provide continuous and current, high quality disclosure to investors and the public markets is not optimal. Stated differently, a regulatory structure that focuses on such transactions is neither efficient nor does it necessarily serve ---------FOOTNOTES---------- -[3]- A number of expert commentators similarly have called for fundamental reform of the current regulatory system. See, e.g., Roberta Karmel, Is Section 5 an Anachronism?, N.Y.L.J., December 21, 1995, at 3; John C. Coffee, Jr., Is the Securities Act of 1933 Obsolete? The SEC Increasingly Appears to Believe So But Has Not Yet Adopted a Consistent Policy to Replace It, Nat'l L. J., September 4, 1995, at B4; Gerald S. Backman and Stephen E. Kim, A Cure for Securities Act Metaphysics: Integrated Registration, INSIGHTS, May 1995, at 18; Joseph McLaughlin, 1933 Act's Registration Provisions: Is Time Ripe for Repealing Them?, Nat'l L. J., August 18, 1986, at 44. ==========================================START OF PAGE 3====== the public interest well, especially in light of the relative size -- 35 times larger -- of the equity trading markets (approximately $5.5 trillion dollars in 1995) as compared to the primary markets (approximately only $155 billion in 1995).-[4]- If the regulatory focus is shifted to a company registration model that would replace the transactional registration requirements, issuers would benefit from the elimination of the increasingly complex, but often ineffective, series of regulations and concepts fashioned over the years to preserve those transactional requirements. Eligible companies would have easier access to the capital markets with lower regulatory and transaction costs, enabling companies to tap the equity markets far more often than they do now. Equally as important, adoption of a company registration system would allow the Commission to eliminate those anomalies under the current system that function to deny investors the protections originally contemplated by the Securities Act, and to make the necessary adjustments to secondary market disclosure practices and due diligence responsibilities that would benefit investors and provide better continuous disclosures to the markets. The Committee recognized that the task of streamlining and simplifying the current regulatory system would be beneficial. Likewise, enhancing investor protection is always desirable. ---------FOOTNOTES---------- -[4]- See Figure 2 in the Addendum to Appendix A of the Report. ==========================================START OF PAGE 4====== Each of these goals could be accomplished easily at the expense of the other by dispensing with or adding burdens, restrictions, or liability. However, the Committee assumed the far more difficult task of crafting a system that both streamlines and simplifies the offering process, thereby lowering costs, while also enhancing investor protection and the integrity of corporate disclosures. The Committee believes that this company registration model, which would accomplish both goals, is superior to an approach that accomplishes only one. The Committee's approach represents a different concept in regulatory problem-solving -- crafting a whole model -- as opposed to effecting incremental changes to particular regulations. The recommendations of this Committee build upon the work of prior Commission committees and task forces,-[5]- and upon the work of Professor Louis Loss and other members of the American Law Institute in connection with its Federal Securities Code.-[6]- That the time has come to complete the transition to a company registration scheme is underscored by the fact that the ALI Code -- including its centerpiece proposal for ---------FOOTNOTES---------- -[5]- See, e.g., Report of the Advisory Committee on Corporate Disclosure to the Securities and Exchange Commission, 95th Cong., 1st Sess. (Comm. Print 1977) (the "1977 Advisory Committee Report"); Disclosure to Investors, A Reappraisal of Administrative Policies Under the 1933 and 1934 Acts, Report and Recommendations to the SEC from the Disclosure Policy Study (March 27, 1969) (the "Wheat Report"). -[6]- Federal Securities Code (Am. Law Inst.) (1980) (the "ALI Code"). ==========================================START OF PAGE 5====== company registration -- was endorsed by two separate Commissions in 1980 and 1982.-[7]- Experience in the intervening decade has only reinforced the advisability of modernizing the current system. The Committee urges the present Commission to complete the transition to a system of company registration, thereby freeing the markets of the costs, uncertainties and confusion engendered by the current transactional registration scheme. The Commission's ultimate goal should be the implementation of a system of company registration that totally replaces the current transactional registration concept for all reporting companies. In order to test most effectively the feasibility of the company registration model, however, the Committee recommends that the Commission establish a pilot program that would be open initially only to certain "seasoned" issuers on a voluntary basis. The Committee has suggested the general framework of the pilot system, recognizing that the Commission has the expertise to craft the details. As the Commission and issuers gain experience under the new system, it could be refined if necessary and then, with appropriate modifications, be made available to a broader class of issuers. Once the company registration system has sufficiently demonstrated its benefits during the pilot, ---------FOOTNOTES---------- -[7]- Statement Concerning Codification of the Federal Securities Laws, Securities Act Rel. 6377 (January 21, 1982); Statement Concerning Codification of the Federal Securities Laws, Securities Act Rel. 6242 (September 18, 1980). ==========================================START OF PAGE 6====== regulatory simplification could be completed through rulemaking and/or legislative changes, as necessary or appropriate. 2. Identified Problems of the Current Transactional System-[8]- The Committee identified uncertainties, complexities and anomalies in the current transactional registration system that increase costs of capital formation when a public trading market already exists for an issuer's securities and adequate information concerning the issuer is widely disseminated and followed in that market, without providing significant countervailing benefits to investors. These costs are both direct and indirect. a. Procedural Requirements of the Registration Process Statutory limitations and regulatory restrictions on solicitation activities prior to and during the registration process make it difficult for reporting companies to distinguish between permitted and prohibited market communications. Companies and other offering participants therefore have limited their ordinary-course market communications unnecessarily when contemplating or conducting a public offering. In the event of improper soliciting activities (called "gun-jumping"), the Commission may delay an offering, resulting in a possible loss of a temporary market opportunity. The ability of an issuer to ---------FOOTNOTES---------- -[8]- For a more in-depth discussion of the issues outlined in this section, see Appendix A to the Report. ==========================================START OF PAGE 7====== control the timing of its public offering, and therefore its ability to take advantage of a favorable market opportunity, also is affected by both the uncertainty of selection of its registration statement for Commission staff review and the length of the resultant delay if so selected. This uncertainty continues to impact even those companies eligible to register securities under the shelf registration system, who may wish to make immediate offerings, or "takedowns," after filing the shelf registration statement, but who must wait until any possible staff review of the registration statement is complete, before takedown is permitted. In addition, the mandatory nature of the prospectus delivery obligation in connection with a registered offering under the current system restricts the ability of the issuer to tailor the required document to suit the varying needs of prospective investors. Moreover, and perhaps more importantly, prospectus disclosure under the current system frequently is not even received by investors until after an investment decision is made. This anomaly defeats the primary purpose of mandated prospectus delivery -- that investors receive all information material to an investment decision before making that decision. Similarly, under the current system, the prospectus supplement is not required to be filed with the Commission until two days after it is delivered to investors in the primary offering. Although the purchasers may have received key pricing and other transactional information orally from participating ==========================================START OF PAGE 8====== broker-dealers at the time of takedown, the market frequently does not have the information contained in the prospectus supplement until days after completion of the shelf offering. Thus, investors trading in the secondary markets contemporaneously with a shelf offering do not have equal access to material information until after their trading decision is made, even though their investment decision takes place at the same time as the primary offering. Perhaps more importantly, one of the central tenets of the current shelf process -- namely the existence of an efficient market for the issuer's securities that helps establish the price for those securities -- is violated because the market does not have timely access to this prospectus supplement information. Consequently, to the extent the market is being relied upon to help set the price for the primary offering, it is being denied the full information it needs to do so. This disparity in the regulatory system exists because, under the current transactional registration system, the focus is on information given to purchasers in the offering, not the market. Under the company- focused approach, by contrast, there is a greater concern for the quality and timeliness of information available to the market and all investors. Further driving the need to reassess this process is the development of new technologies that are changing rapidly the way in which information is communicated and disseminated in our markets. Present and future changes in technology, particularly ==========================================START OF PAGE 9====== in light of the advent of T+3 clearance and settlement, electronic dissemination of offering documents, and the development of trading markets over the Internet, can only continue to challenge the current system. Finally, the registration process itself imposes direct expenses on an issuer in the form of legal, accounting, underwriting, printing and filing fees, as well as indirect costs due to the effects of market overhang and short-selling and related activities on the market price of an issuer's securities traded in the secondary markets. Under a company registration system that allows "just-in-time" financing techniques, these costs should be reduced. ==========================================START OF PAGE 10====== b. Technical Distinctions and Concepts Designed to Protect the Integrity of the Transactional Registration Paradigm While originally devised to prevent evasion of the transactional registration requirements, the technical distinctions and concepts developed by regulation and/or interpretation over the years -- such as "restricted" securities, integration of offerings and limitations on general solicitations -- have added a significant degree of confusion and uncertainty, as well as constraints and costs, to the capital formation process. These concepts and requirements increasingly have been condemned as "metaphysics,"-[9]- and are among the reasons why issuers often offer securities in the private and offshore markets. Public companies that today wish to avoid the disadvantages of the current registration scheme currently bear the burden of an illiquidity discount in private placements of securities or the additional logistical burdens of an overseas offering. In the case of seasoned companies, these restrictive concepts have limited practical or economic substance in terms of investor protection. Given that they drive seasoned companies to markets where there are in fact little or no Securities Act investor protections, these concepts are increasingly difficult to defend on a legal, economic or investor protection basis. ---------FOOTNOTES---------- -[9]- See, e.g., Stanley Keller, Basic Securities Act Concepts Revisited, INSIGHTS, May 1995, at 5; Gerald S. Backman and Stephen E. Kim, A Cure for Securities Act Metaphysics: Integrated Registration, INSIGHTS, May 1995, at 18. ==========================================START OF PAGE 11====== c. Changes in the Markets and Offering Processes, and the Effect on Investor Protection While the public, private and offshore markets are still treated as technically distinct and separate markets under the Securities Act, the traditional boundaries between and among such markets have increasingly become blurred and distorted by technological advances and evolving trading practices. The Committee questions whether the regulatory distinctions drawn between and among these markets should, or can, be maintained for seasoned issuers. Through the use of such strategies as hedging techniques, equity forwards, and equity swaps, and so-called "A/B exchange offers" and "PIPE" transactions-[10]- that the Committee believes promote form over substance, the vital investor protection concepts underpinning the Securities Act are losing their effectiveness. Simply put, through these techniques, issuers in essence can engage in public offerings without providing investors with the benefits and remedies of the Securities Act at the time of the investment decision. The nature of our securities markets has changed dramatically over the last sixty years. The rate of change has been even more striking in the last two decades. In the Committee's view, the statutory schemes first enacted in 1933 and ---------FOOTNOTES---------- -[10]- For an explanation of these devices and additional information regarding the blurring of public, private, domestic and offshore markets and the consequent effects on investor protection, see Appendix A to the Report at p. 38-45. ==========================================START OF PAGE 12====== 1934 were well adapted to the markets of the time.-[11]- Sixty years ago, the secondary trading markets for equity were far smaller and less active than they are today -- only a few times the size of the primary markets, as opposed to 35 times today -- and there were few mechanisms for the general public to make investments other than through the direct purchase of corporate shares in primary offerings. Since then, trends such as the growth in the secondary trading markets for equity relative to the primary issuance market, the general shift of retail investor participation from the primary markets to the secondary markets, and the increasing institutionalization of the markets for both debt and equity, have called into question whether the current statutory provisions of the Securities Act continue to protect investors as efficiently and effectively as possible. In addition, ---------FOOTNOTES---------- -[11]- For example, during the 1930s and 1940s, on average, the number of registration statements declared effective on a yearly basis was approximately 400 as compared to over 8,000 today (including all registration forms). Annual Report of the Securities and Exchange Commission for the fiscal years 1935 through 1950; Division of Corporation Finance data. In the past, companies tapped the equity markets only when necessary because costs were extremely high. Prospectuses, even for the most seasoned issuers, were fully stand-alone documents presenting an entire picture of a company, without incorporation by reference to other disclosure documents. Offerings frequently took months to complete, and the process for seasoned issuers was not very different from the process for an initial public offering. Moreover, the SEC Commissioners themselves would actually meet to review the few registration statements that were submitted each week and provide written comments on the disclosure presented in the registration statement. ==========================================START OF PAGE 13====== evolutionary changes in the rules governing the offering process made by the Commission over time to facilitate issuer access to the markets, including the increased reliance on Exchange Act reports to satisfy many core Securities Act disclosure requirements, the adoption of shelf registration for primary offerings and the timing of prospectus delivery, may be impairing the ability of issuers' boards of directors, underwriters and independent accounting firms to perform their traditional Securities Act "due diligence." 3. Company Registration as the Logical Conclusion of Evolutionary Change in the Regulatory Process Past initiatives demonstrate that, while also enhancing investor protection, cost savings can be anticipated from a transition to a company registration system. In this regard, the Committee does not write on a blank slate. Almost thirty years ago, Milton Cohen described the need for a dramatic transformation in focus and thinking regarding the regulatory structure of the federal securities laws, when he wrote: [i]t is my thesis that the combined disclosure requirements of [the Securities Act and the Exchange Act] would have been quite different if the [Acts] had been enacted in opposite order, or had been enacted as a single, integrated statute -- that is, if the starting point had been a statutory scheme of continuous disclosures covering issuers of actively traded securities and the question of special disclosures in connection with public offerings had then been faced in this setting. Accordingly, it is my plea that there now be created a new coordinated disclosure system having as its basis the continuous disclosure system of the [Exchange] Act and treating ==========================================START OF PAGE 14====== "[Securities] Act" disclosure needs on this foundation.-[12]- Further suggestions regarding the integration of the disclosure and regulatory schemes of the Securities Act and Exchange Act -- actions moving towards a company registration model -- were raised in the 1969 Wheat Report,-[13]- the 1977 recommendations of the SEC's Advisory Committee on Corporate Disclosure,-[14]- and the ALI Code.-[15]- As a result, the integrated disclosure system and the shelf registration process were implemented by the Commission in the early 1980s, and have now firmly taken hold and demonstrated their benefits. Moreover, with the adoption of Rule 144A in 1990, the Commission began the development of a limited institutional trading market in certain restricted securities, thereby permitting greater liquidity and a lower illiquidity discount, and consequently reducing the regulatory costs imposed by resale restrictions on these securities. Similar to public offerings, Rule 144A placements generally are conducted with the assistance of investment banking firms. In addition, Rule 144A placements often involve the use of detailed offering circulars making ---------FOOTNOTES---------- -[12]- Milton H. Cohen, "Truth in Securities" Revisited, 79 Harv. L. Rev. 1340, 1341 - 1342 (1966). -[13]- Wheat Report, supra n.5. -[14]- 1977 Advisory Committee Report, supra n.5. -[15]- ALI Code, supra n.6. ==========================================START OF PAGE 15====== extensive disclosures regarding the offering as well as the company and its financial condition. This is the case even though there are no explicit Commission-mandated disclosure requirements applicable in a Rule 144A placement.-[16]- Due to the innovative ideas of integrated disclosure (including incorporation by reference), short-form shelf registration and Rule 144A, offerings today can be conducted on a more cost-efficient basis than under the traditional model for underwritten public offerings: Under the current selective review system, the majority of registration statements relating to public offerings by seasoned issuers are not reviewed by the Commission's staff prior to effectiveness. Moreover, in the case of primary shelf offerings, the information contained in prospectus supplements is never required to be pre-reviewed by the staff prior to the takedown of securities from the shelf. A shelf registration statement need not describe in advance a specific contemplated offering. Since 1992, issuers have been able to complete an offering under a universal shelf registration statement that simultaneously registers an unspecified amount of each enumerated type of security registered, subject only to the unallocated total dollar amount of securities being registered and a presumed two-year limit on the amount reasonably expected to be offered. The traditional methods of prospectus delivery are not necessary in connection with all public offerings. Today, in the case of offerings by seasoned issuers, much of the crucial company-related information is incorporated by reference from the company's filed reports, rather than physically delivered to investors as part of the prospectus. The success of the Rule 144A institutional market evidences that an active primary issuance market can ---------FOOTNOTES---------- -[16]- Of course, the general antifraud provisions of the federal securities laws still apply. ==========================================START OF PAGE 16====== develop, with procedures and disclosure documents delivered to investors that better suit their needs, in the absence of a mandated Securities Act transactional registration process, and disclosure delivery requirements. That the Commission already has travelled so far from the original transactional disclosure model does not imply, however, that there is nothing more to be done to enhance investor protection and facilitate capital formation. It should be noted that, at each phase in the development of the current system, this country's securities markets were functioning well and were the deepest, most liquid and largest of any in the world. With each transition to a new phase, the markets improved. The favorable experience with these reforms illustrates that issuers, under the proper conditions, can be freed from many of the constraints of the transactional registration process not only without undermining the Securities Act's investor protection goals but also, if appropriately and thoughtfully done, by better satisfying them. The overall success of the current integrated disclosure and shelf offering systems, and the Rule 144A market, provides the Commission with a solid foundation for making additional improvements to facilitate issuer access to the U.S. public markets consistent with these goals. 4. The Benefits of the Company Registration System as Compared to the Current Transactional Regulatory System The reforms that would be instituted under the proposed company registration system are part of this ongoing evolutionary process. Transactions under company registration would not ==========================================START OF PAGE 17====== differ significantly from transactions under the current universal shelf system, in the sense that the issuer in advance of an offering need only describe its financing plans in general terms, and would not be subject to a separate registration process and staff review when it wishes to proceed to market. There will, however, be significant advantages for the issuer and its shareholders over the current shelf system because the company registration system essentially will make the Form C-1 the equivalent of a shelf registration statement that is applicable on a continuous basis for all future offerings. The various elements of company registration that will effect this change include the pay-as-you-go fee system, the elimination of the need to register a specified amount of securities in advance (which should alleviate the concerns regarding equity market overhang that persist notwithstanding the adoption of the unallocated or "universal" shelf procedure), as well as the extension of the streamlined offering process to most acquisitions. Smaller, more frequent, offerings likewise will be facilitated by the simplicity and ease of the company registration system. In addition, elimination of current restrictions on at-the-market equity offerings will eliminate the lingering confusion surrounding this concept. Moreover, issuers should realize significant cost savings as a result of the more flexible prospectus delivery requirements, while maintaining, and even enhancing, the nature and amount of disclosure on file with the Commission and hence disclosed to the ==========================================START OF PAGE 18====== markets at the time of sale. Finally, the full company registration system eliminates the unnecessary application of resale restrictions on most directors and officers. Company registration also would offer issuers and investors significant advantages over Rule 144A: all the speed and predictability of a Rule 144A offering; no illiquidity discount, which generally now attaches to restricted (unregistered) securities; offering not limited to a prescribed class of qualified institutional buyers; offered securities not limited by fungibility restrictions; satisfaction of investor demand for registered securities; investors afforded the Securities Act protections of a registered transaction; and avoidance of uncertainties arising from potential integration with non-144A offerings. Unlike the current shelf rule and even Rule 144A, full implementation of a company registration model would simplify the complex regulatory quilt of rules and doctrines that has been patched together in an effort to preserve the transactional focus of the existing regulatory scheme and its core registration requirement. Thus, the need to superimpose legal distinctions on economically indistinct markets would be eliminated. At the same time, and as important, company registration would provide an opportunity to buttress the fundamental investor protections that have come under increasing stress as the markets have experimented with more efficient offering methods, some of ==========================================START OF PAGE 19====== which are outside the scope of the Securities Act altogether. As efforts have been made to accommodate demands for more flexibility under the current system, and as issuers and other sellers of securities have found mechanisms to utilize exemptions and jurisdictional limitations under the current system because they find its requirements too burdensome, the core protections of the current system have begun to erode.-[17]- By contrast, with a rationalized, streamlined and cost effective regulatory process in place, the incentive for issuers to utilize jurisdictional or other means to escape the Securities Act should be substantially diminished. Concomitantly, the opportunity is presented to reinstate and provide for better investor protections. At base, by reducing unnecessary costs of complying with the registration requirements of the Securities Act, the Committee expects that more issuers will register more offerings, thereby extending the benefits of the Securities Act to more investors. Company registration also will further the longstanding Commission goal of improving the quality and reliability of information disseminated by public corporations on an ongoing basis to a level comparable to that traditionally provided in primary offerings.-[18]- Disclosure will be required on an ---------FOOTNOTES---------- -[17]- See p. 36-54 of Appendix A to the Report for more detail. -[18]- As Milton Cohen observed in 1985, "[d]isclosures for [Exchange] Act purposes still tend to be taken less seriously, and to be of lower quality, than (continued...) ==========================================START OF PAGE 20====== Exchange Act Form 8-K of transactional information and material developments at the time of virtually all equity offerings. This requirement also will ensure full availability to investors of Securities Act (as well as Rule 10b-5) remedies for material deficiencies in that information, facilitate the due diligence efforts of underwriters and other participants in the offering, and provide material information regarding the issuer and the transaction to the markets earlier than under the current system. Reordering and rationalizing the various gatekeeping or monitoring functions to provide greater oversight of the issuer's disclosures on an ongoing basis will be accomplished through the provision of more detailed and explicit guidance regarding the due diligence and reasonable care defenses of certain gatekeepers under Sections 11 and 12(a)(2) of the Securities Act. Such guidance should encourage companies to adopt interim reviews of financial information by outside auditors, a disclosure committee of the board to perform continuous oversight of the disclosure process, and various other measures. In addition, the flexibility company registration provides to issuers to tailor offering materials to the needs of ---------FOOTNOTES---------- -[18]-(...continued) those historically provided, and still aspired to, under the [Securities] Act despite the advent in 1982 of incorporation by reference of Exchange Act reports into Securities Act registration statements." Milton H. Cohen, The Integrated Disclosure System -- Unfinished Business, 40 Bus. Law. 987, 992 (1985). ==========================================START OF PAGE 21====== investors, including putting them in plain English, will result in those documents being more readable and more informative, just as "profile prospectuses" in the mutual fund industry are more readable. Thus, company registration complements well, and furthers, the potential application of the Commission's "plain English" initiative. The Committee recognizes that there may be costs associated with an issuer's opting into the pilot, particularly in connection with the adoption of the recommended disclosure enhancements discussed below. In the Committee's view, however, issuers should embrace both the mandatory and voluntary disclosure enhancements because they reflect better practices, should help reduce the potential for litigation based on material misstatements or omissions, and will, in the long run, result in lower costs to the issuer when it proceeds to market. Because participation in a company registration system would be voluntary during the pilot, companies would be free to make their own judgments whether the benefits of more efficient and less costly access to capital pursuant to the company registration system outweigh any attendant costs. B. Key Elements of the Recommendations The following is a summary of the basic recommended features of the company registration system and pilot, as well as the Disclosure Committee proposal. A full description of the specific elements of the pilot is provided in Appendix B and in the Term Sheet. ==========================================START OF PAGE 22====== 1. The Offering Process. The basic principle of a company registration system is that the regulatory process is company- based, rather than transaction-based. Once meeting eligibility standards, companies would register with the Commission. To become company-registered, an eligible company would file a Form C-1 registration statement, much like the current process for registering a class of securities under the Exchange Act, and also disclose its plans to sell securities from time to time in the indefinite future on a company-registered basis. Much like today, companies also would file Exchange Act reports, which would automatically be incorporated into the Form C-1, and the information in the company's public file would then form the primary basis for decisions by the investing public with respect to a registered company's securities. Only a nominal registration fee would be paid when the company is first registered. The issuer would pay a full registration fee at the time of sale based on the amount of securities to be sold. In effect, this process would create a "pay-as-you-go" system somewhat similar to that now available to open-end investment companies registered under the Investment Company Act of 1940. Under a full company registration system, once a company is registered and filing periodic and current reports, most routine sales and resales of the company's securities would be consummated immediately without any additional Commission staff review prior to the sale of the security, just as is the case ==========================================START OF PAGE 23====== today for takedowns from a shelf, and would be based primarily upon the information contained in the company's updated Exchange Act disclosure file. All subsequent sales of covered securities by registered companies and their affiliates (outside Rule 144) would be deemed to be covered by the registration statement, and thus would be registered for purposes of the Securities Act. All purchasers of securities from the issuer or its affiliates, regardless of the nature of the transaction, thus would receive freely tradeable securities, as well as the benefit of all statutory remedies that now attach to information disseminated in connection with a registered offering of securities. Therefore, investor protection would be enhanced and extended to a broader class of transactions, while the need for concepts such as gun- jumping and restricted securities would be eliminated. At the time of each offering, the issuer would file with the Commission material information relating to both the specific offering, as well any material updates to the filed company- related information that has not already been disclosed in its filings at the time of the transaction. In the case of non- convertible debt and de minimis equity offerings, that information could be filed by the issuer with the Commission on a Form 8-K or, a prospectus supplement, and the registration fee for the specific offering would be paid. In the case of an equity offering over a de minimis threshold (e.g., more than three percent of the public float of the security in any three business day period), this information must be filed on a Form 8- ==========================================START OF PAGE 24====== K, rather than merely in a prospectus supplement, on a date no later than the date of the first sale. This Form 8-K transactional filing, which is not required today for takedowns from a shelf registration, will ensure that this important information is incorporated into the registration statement and thus within the coverage of Section 11 liability, and facilitate the due diligence inquiries of underwriters and other gatekeepers, thereby improving the quality of the disclosure made to investors in both the primary and secondary trading markets. The Committee also recommends that, during the pilot, this Form 8-K filing requirement be applied to all non-de minimis equity offerings utilizing the current shelf registration process. In further distinction to the current system, where a Form 8-K is required to be filed or is voluntarily filed for the purposes of the incorporation by reference method of prospectus delivery (as discussed more fully below), any information that is material company-related disclosure (including, where necessary, an updated Management's Discussion and Analysis) that is not yet in the public file would be required to be filed some period of time before the sale (which could be, for example, the same day as, or one to three business days before, the transaction, depending on the issuer and the information) to provide an adequate opportunity for the market to absorb the information. (The transactional information, however, normally need not be filed until the day of sale.) The company registration system thereby corrects a clear infirmity in the current system, ==========================================START OF PAGE 25====== especially where transactions with purchasers are priced on the basis of the current market price of the issuer's securities. The filing requirements regarding an auditor's consent to the use of its report in connection with the issuer's financial statements would remain unchanged from those followed today with respect to primary shelf offerings.-[19]- Thus, company registration would enhance the timeliness, quality, and level of information about companies and their offerings that currently is made available to investors and the markets through Commission filings. At the same time, as noted below, company registration would afford companies offering their securities to the public the flexibility to tailor the disclosure documents actually delivered to investors to the nature of the transaction and the demands of the offering participants. 2. Prospectus Delivery Requirement. In routine offerings, issuers would have greater flexibility with respect to the delivery of both the company-related and transactional information mandated in a public offering. This flexibility regarding the delivery of information to investors is in contrast to the filing of disclosure documents with the Commission: those filed documents will be subject to the same Securities Act content requirements but, in many instances, will be filed on an accelerated basis. Rather than imposing formal, full-fledged delivery requirements in connection with all issuances of ---------FOOTNOTES---------- -[19]- See p. 24-28 of Appendix B to the Report. ==========================================START OF PAGE 26====== securities to the public, the appropriate style and level of company and transactional disclosure that physically would be delivered to investors would be determined in most offerings by considerations relating to informational demands of participants in the particular offering, thereby facilitating more useful and more readable ("plain English") disclosure. Specifically, in routine offerings under company registration, where physical delivery of a traditional prospectus would not be mandated because the requisite information has been filed on a Form 8-K and may be incorporated by reference and constructively delivered, issuers and underwriters would be free to decide whether to use some form of a formal prospectus and what information to disclose in that prospectus if used.-[20]- The Committee expects that the information that actually is delivered to investors in the form of a term sheet, selling materials or a more formal prospectus, would be the information that the issuer deems most relevant and material to the investment decision. Because all mandated company and transactional disclosure must be filed with the Commission and made part of the registration statement, strict liability will attach to this information. To the extent an issuer elects to ---------FOOTNOTES---------- -[20]- Just as under the current system, to the extent that disclosure made in any delivered document might be rendered misleading by the omission of information contained only in documents filed with the Commission, such as the transactional Form 8- K, the delivered documents must include such information. See p. 17-18 to Appendix B of the Report. ==========================================START OF PAGE 27====== use selling material without delivering a statutory prospectus, those materials that ordinarily would not be filed at all and would have only Rule 10b-5 liability, will now be filed and have Section 12(a)(2) liability. As is the case with the takedown prospectus supplement under today's shelf procedures, there would be no prior Commission staff review of any disclosure document prior to the sale of the securities (although the Commission staff may choose to review such a document, as it might any other, in conjunction with a review of the company's disclosure file).-[21]- In those circumstances where the company registration system would continue to mandate formal prospectus delivery, physical delivery of the formal prospectus must be provided to non- accredited investors in sufficient time to influence the investment decision.-[22]- This is in sharp contrast to the current system, where, as noted above, the disclosure ---------FOOTNOTES---------- -[21]- Even in the absence of Commission staff review at the time of the offering, issuers and underwriters still must comply with all other applicable regulatory requirements, e.g., state Blue Sky requirements, exchange and Nasdaq listing requirements, and NASD review of underwriter compensation. -[22]- In these non-routine equity transactions, the prospectus received by the non-accredited investors prior to the sale would be similar to the preliminary prospectus mandated in initial public offerings (cf. Rule 15c2-8 under the Exchange Act [17 CFR 240.15c2-8]) and also routinely disseminated in non-shelf repeat equity offerings where the price-related and other current information often would not be incorporated into the document prior to sale. ==========================================START OF PAGE 28====== document frequently is received by investors at the time of the confirmation of sale -- often days after the investment decision has been made. For purposes of the pilot, the different levels of transactions requiring varying levels of prospectus delivery essentially fall into three tiers. The Commission may wish to consider whether the second tier (Nonroutine Transactions) is necessary and whether it is practicable to require delivery of prospectus information prior to the sale, or whether the system could be simplified by extending the procedure for Routine Transactions to this second tier. o Routine Transactions (e.g., all offerings of all covered securities, except offerings of voting equity amounting to 20% or more of the existing public float of the security;-[23]- similar limitations on "routine" issuances for other types of securities could possibly be adopted as well)(This category established for prospectus delivery purposes encompasses the de minimis equity and other types of offerings that are exempt from the mandatory Form 8-K filing requirement.) The issuer could continue to use traditional prospectus delivery. In the alternative, the issuer may incorporate by reference any publicly filed information into a document serving as the prospectus, such as the confirmation of sale or selling materials. Issuers would file transactional and updating disclosure with the Commission on a Form 8-K and incorporate this information as well as any other ---------FOOTNOTES---------- -[23]- Based on data from 1992-1994, approximately 70% of all firm commitment common equity offerings would be deemed routine under this threshold. See Figure 6 in the Addendum to Appendix A of the Report. ==========================================START OF PAGE 29====== necessary information in other filed reports.-[24]- Much like under shelf registration today, the disclosure incorporated by reference need not be repeated in the document serving as the prospectus. All mandated disclosure, including transactional disclosure, may be incorporated by reference from Exchange Act reports, a more flexible standard than under the current shelf registration system where transactional disclosure may not be incorporated by reference and must actually be delivered (albeit frequently after the investment decision has already been made). If the issuer wishes to use selling materials without having delivered a formal prospectus, the issuer would simply incorporate by reference into those selling materials the transactional disclosure and any material company-related updating disclosure (i.e., the disclosure currently required under shelf registration to be delivered in a formal prospectus) as well as all of the Exchange Act reports on file. The selling materials then would be treated as the statutory prospectus, including for liability purposes. This new flexibility to use abbreviated selling materials without incurring the obligation to deliver physically a full statutory prospectus will facilitate the development of summary prospectuses and plain-English disclosure documents. o Non-routine Transactions (e.g., offerings of voting equity amounting to 20% or more of existing public float of the security) The current requirement under shelf registration that transactional information (and any material updating company disclosure not already on file with the Commission) actually be delivered to investors in a formal prospectus (as opposed to incorporated by reference from filed documents) would be retained. Where this more traditional ---------FOOTNOTES---------- -[24]- With respect to the filing requirement, unless the transaction is de minimis, the Form 8-K would be required to be on file in any equity offering regardless of whether the information is incorporated into a document serving as a prospectus. ==========================================START OF PAGE 30====== prospectus is mandated to be delivered to the investor, delivery should be required to be made to investors prior to sale. ø Traditional prospectus delivery may be useful in transactions that would alter significantly the information previously disseminated to the markets and that likely would be accompanied by significant selling efforts. Physical delivery of a prospectus would not be required for accredited investor purchasers. o Extraordinary Transactions (securities transactions that fundamentally change the nature of the company (e.g., offerings of voting equity amounting to 40% or more of the existing public float of the security)) Traditional prospectus delivery would be mandated as in non-routine transactions. The opportunity for Commission review of the prospectus prior to its use would be retained for this category of transactions. Physical delivery of a prospectus would not be required for accredited investor purchasers. ==========================================START OF PAGE 31====== COMPANY REGISTRATION PILOT SIZE/TYPE OFFERING ----------------------------------------------Equity--------------------------------| Non-convertible Debt De Minimis Routine Non-routine Extraordinary <=3% >3% <20% >=20% <40% >=40% Transactional Optional Yes Yes Optional 8-K -[1]- Yes Filing required (at or prior to sale) No (unless No (unless No (unless No (unless Post- fundamental fundamental fundamental Yes fundamental effective change to change to change to change to Amendment -[2]- R/S) R/S) R/S) R/S) (must be declared effective by staff before (1) (1) Traditional Traditional No (if takedown) Traditional Traditional prospectus prospectus choose to be prospectus prospectus supp. supp. covered, Prospectus supp. supp. delivered to delivered to treat as Delivery -[2]- delivered at delivered at investor investor Routine or prior to or prior to prior to prior to regardless confirm; or confirm; or confirm and confirm and of face (2) (2) at same time at same time amount of Transactional Transactional filed with filed with offering) SEC under SEC under information information cover of 8-K. cover of 8-K. filed on filed on Form 8-K and Form 8-K and Incorporation Incorporation incorporated incorporated by by by reference by reference reference reference 3 into 3 into option option confirm or confirm or available available sales sales only with only with literature, literature, respect to respect to which is which is accredited accredited then then investors investors delivered as delivered as statutory statutory prospectus prospectus at or prior at or prior to confirm to confirm -[1]- All equity and equity equivalents. -[2]- Voting equity or equivalents only. -[3]- Where disclosable (e.g., per 10b-5 (Basic) and/or 8-K line item) material change regarding company has occurred since last 10-K, 10-Q or 8-K and using incorporation by reference method of prospectus delivery, must file 8-K reporting change in sufficient time before takedown to permit market assimilation (e.g., 1 to 3 days). ==========================================START OF PAGE 32====== 3. Scope. Participation in the company registration pilot would be voluntary and would be limited to a senior class of seasoned issuers, i.e., issuers with a $75 million public float, two years of reporting history, and a class of securities listed on a national securities exchange or traded on the National Market System of the Nasdaq Stock Market. Thus, the current Securities Act transactional system, including specifically, where applicable, Commission staff review of transactional documents prior to the offering, would be retained for all other issuers including for those engaging in initial public offerings. Foreign issuers could participate if they adopt the reporting requirements applicable to domestic companies and otherwise meet the eligibility criteria, including adopting the disclosure enhancements described below. The Committee recommends, however, that the Commission consider whether accommodations should be made for foreign issuers similar to those that permit such issuers to use the shelf today. The extent to which smaller, less seasoned companies could benefit from the system will depend on experience with the pilot and, if otherwise deemed appropriate based on such experience, may require mandating such additional protections as traditional prospectus delivery, greater advance notice for prospective investors of company and transaction information before any offering, or the retention of the potential for staff review of ==========================================START OF PAGE 33====== annual financial information before its use in connection with an offering. A company may opt out of the pilot by withdrawing its Form C-1, but would not be eligible to opt back into the company registration system for a period of two years. For purposes of the pilot, noncompliance with the issuer eligibility conditions or any of the mandatory disclosure enhancements in any material respect would result in the loss of eligibility to make offerings pursuant to the Form C-1 for a two-year period. Moreover, an issuer would have to be current in its reporting obligations at the time of each offering. Under full company registration, all issuances of any covered security by a registered company or its affiliates, including those issuances made for acquisitions, would be afforded the same legal status and carry the same protections as securities registered under the Securities Act today. Accordingly, all securities sold by a registered company would be freely tradeable. Thus, a principal benefit of the comprehensive nature of company registration is that distinctions currently existing between public and nonpublic offerings (with the resultant formalities and restrictive concepts such as gun- jumping and integration) would be eliminated. For example, securities sold overseas by a registered company would be deemed registered to the extent of any flowback of those securities into the United States, providing investors in the United States the ==========================================START OF PAGE 34====== same protections they would have had if the securities had been sold initially in this country. In addition, by thus eliminating the risk of unregistered distributions through the use of conduits, the system also eliminates any need for restrictions on resales by affiliates and statutory underwriters. Consequently, only the Chief Executive Officer and inside directors, as well as holders of 20% of the voting power, or 10% of the voting power with at least one director representative on the board, need be subject to affiliate resale restrictions. Similarly, the statutory underwriter concept would apply only to persons engaged in the business of a broker-dealer (whether or not so registered) who participate in a distribution of securities by a registered company or its affiliates under the Form C-1. At their option, under the pilot, participating companies may elect to continue to conduct offerings not registered under the Securities Act (such as private placements and other transactional exemptions, and offshore offerings under Regulation S) for all types of securities, i.e., "modified company registration." Although the Committee was aware that the addition of a modified company registration option would add complexity, the Committee was concerned that, at this initial stage and until issuers become comfortable with the company registration concept, the loss of the ability to conduct exempt private placement and offshore offerings could be a deterrent to ==========================================START OF PAGE 35====== the voluntary use of the company registration system.-[25]- Therefore, to permit a meaningful test of the company registration concepts during the pilot stage, the Committee believes that issuers should be afforded the option of continuing to conduct nonregistered offerings, while still availing themselves of most of the benefits of the system. Companies could choose either to waive transactional exemptions, or determine to preserve the option to exclude those transactions from the company registration system by using the modified version of this system. Under either approach, however, companies could choose to exclude straight debt securities. If a company chooses to conduct an exempt offering, the securities issued outside the Form C-1 would remain subject to the current concepts of restricted securities, and the resale restrictions and registration requirements applicable to current affiliates and statutory underwriters would remain. Exempt offerings, however, would not be subject to integration with offerings made pursuant to the company registration statement. The benefits resulting from registration, including the issuance of freely tradeable securities in what otherwise would have been a private transaction resulting in restricted securities, should outweigh any additional costs imposed by registering the securities under the system. Illiquidity ---------FOOTNOTES---------- -[25]- Transcript of May 8, 1995 Advisory Committee Meeting at 177 (statements of Professor Coffee). ==========================================START OF PAGE 36====== discounts typically imposed by the market on non-registered securities should be eliminated for all securities issued under the company registration system. As noted, these discounts can range up to 20 percent for equity, compared to 0 basis points market discount for shelf registered equity offerings (5 percent total underwriter spread and fees).-[26]- Also, issuers would ultimately benefit by the reduction or elimination of the costs and uncertainties that today result from complex interpretive concepts and the concomitant need to monitor transactions in restricted securities. 4. Disclosure Enhancements. In the Committee's view, enhancing the quality and reliability of secondary market reports is an integral part of an effective company registration system, because these reports are the cornerstone of the offering disclosures by company-registered issuers. While the Committee does not consider the quality and reliability of the current secondary market disclosure system to be so deficient as to compromise investor protection, the Committee does find that there is room for improvement.-[27]- With registered companies having almost immediate access to the capital markets, new measures are necessary and appropriate to provide assurance regarding the integrity of the disclosure disseminated by those companies on an ongoing basis. For these reasons, the Committee ---------FOOTNOTES---------- -[26]- See p. 37 and Table 1 of Appendix A to the Report. -[27]- See p. 45-49 of Appendix A to the Report. ==========================================START OF PAGE 37====== believes that secondary market disclosures must be improved and enhanced. The Committee recommends that any company registration system adopted by the Commission include a series of procedural disclosure enhancements as part of opting into company registration and remaining in the system. The purpose of these disclosure enhancements is to ensure that those individuals and entities best equipped to guard the integrity of the disclosure provided in the company's filed reports focus increased attention on these disclosures: Top Management Certifications Certification to the Commission (not a filed document) would be required of two of any of the following four officers, attesting that they have reviewed the Form 10-K, the Form 10-Qs and any Form 8-Ks reporting mandated events, but not for voluntarily filed Form 8-Ks, and that they are not aware of any misleading disclosures or omissions: the chief executive officer, chief operating officer, chief financial officer, or chief accounting officer. The attestation would be required upon the filing of each such document with the Commission. Management Report to Audit Committee A report prepared by management and addressed and submitted to the board of directors' audit committee (or its equivalent or the disclosure committee, if adopted and different from the audit committee) describing procedures followed to ensure the integrity of periodic and current reports and procedures instituted to avoid potential insider trading abuses (e.g., any requirement that company insiders clear trades with the issuer's general counsel).-[28]- This report would be ---------FOOTNOTES---------- -[28]- The recommendation that the Report cover procedures to prevent insider trading was suggested to complement the elimination of Form 144 filings by those affiliates (officers and directors) who no longer would be subject to resale restrictions. Those filings were believed to serve as a mechanism to help police improper insider trading. ==========================================START OF PAGE 38====== made public as an exhibit to the Form 10-K; the report need not be resubmitted on a yearly basis if the described procedures are unchanged. Form 8-K Enhancements Expansion of current reporting obligations on Form 8-K under the Exchange Act to mandate disclosure of additional material developments: ø Material modifications to the rights of security holders (current Item 2 of Form 10- Q); ø Resignation or removal of any of the top five executive officers; ø Defaults of senior securities (current Item 3 of Form 10-Q); ø Sales of a significant percentage of the company's outstanding stock (whether in the form of common shares or convertible securities or equity equivalents); ø Issuer advised by independent auditor that reliance on audit report included in previous filings is no longer permissible because of auditor concerns over its report, or issuer seeks to have a different auditor reaudit a period covered by a filed audit report. For the above items that are required now to be filed on a Form 10-Q, the information therefore would be provided on a current, rather than a quarterly, basis. Moreover, the period within which a Form 8-K must be filed following any mandatory event specified in that form would be accelerated from 15 calendar days to 5 business days. Risk Factors Risk factor analysis disclosure requirements to the extent currently required in an issuer's Securities Act filings would be added to the Form 10-K. Voluntary Measures Voluntary measures would be encouraged by the opportunity for various gatekeepers to make the due diligence process more efficient, and would consist of: auditor review of interim financial information either consistent with SAS No. 71 or a more detailed interim audit procedure; auditor review of events subsequent to the date of the audited financial statements that may bear materially on those statements ==========================================START OF PAGE 39====== pursuant to SAS No. 37; opinion letters by auditors pursuant to SAS No. 72 and by issuer's counsel that are provided to underwriters and outside directors in connection with offerings; and the establishment of a "disclosure committee" of outside directors (which could be the existing audit committee). 5. Liability While the Committee evaluated alternative liability schemes in its consideration of the company registration system, the Committee has determined that the company registration model should maintain the current Securities Act liability scheme at least during the pilot stage. The Committee believes that the continued application of the current liability scheme will ensure the maintenance of familiar investor protection concepts during the transition from a transactional- based system to a company-based system. In fact, investor protection would be enhanced under the pilot program. Notably, under the current shelf system, companies deliver transactional information in a traditional prospectus supplement that, although filed with the Commission, is not deemed filed as part of the registration statement. As a consequence, investors are denied the core protections of Section 11 of the Securities Act with respect to this information.-[29]- By contrast, the pilot would expand the scope of the Section 11 protections to these disclosures through its requirement of a Form 8-K filing for non-de minimis equity ---------FOOTNOTES---------- -[29]- See Elimination of Pricing Amendments and Revision of Prospectus Filing Procedures, Securities Act Rel. 6672 ( Oct. 27, 1986)[51 FR 39868 (November 3, 1986)]. ==========================================START OF PAGE 40====== offerings. For companies that fully opt into the system, liability also would be expanded to cover transactions that are not now subject to Section 11 liability, such as the flowback of overseas offerings, private placements and other transactions currently deemed "exempt" offerings. In addition, sales literature that today only receives the protection of Rule 10b-5 would, under many circumstances, receive the enhanced protection of Section 12(a)(2) of the Securities Act. 6. Due Diligence In reaching its conclusion to retain the current Securities Act liability structure, the Committee weighed concerns regarding the due diligence responsibilities of various gatekeepers stemming from the expedited nature of the current shelf registration process, and recognized that company registration could further expedite the offering process. Although the current system expects outside parties to act as gatekeepers in the offering process, in practice and for a variety of reasons, such roles are not necessarily being fulfilled in the manner anticipated when the Securities Act was adopted.-[30]- From the outset, the Committee sought to buttress and strengthen the gatekeepers' roles in protecting investors not only in the context of episodic, transaction- specific oversight, but also, and with increased emphasis, in the context of ongoing oversight by those persons in the best ---------FOOTNOTES---------- -[30]- See ABA Committee on Federal Regulation of Securities, Report of Task Force on Sellers' Due Diligence and Similar Defenses Under the Federal Securities Laws, 48 Bus. Law. 1185 (May 1993). ==========================================START OF PAGE 41====== position to monitor the integrity and accuracy of company disclosures. Separately, proponents of the proposed Form 8-K filing requirement at the time of the transaction asserted that such a filing would help serve to focus and facilitate the due diligence inquiries of underwriters. As part of the adoption of company registration, the Committee recommends that the Commission provide interpretive guidance to gatekeepers as to more effective methods of satisfying the "reasonable investigation" and "reasonable care" standards, respectively, of Sections 11 and 12(a)(2) of the Securities Act. In this regard, the Committee recommends expanding the factors (currently enumerated in Securities Act Rule 176) that may be taken into account by gatekeepers or monitors in determining their appropriate due diligence investigation, to refer specifically to compliance with the mandatory and voluntary procedures outlined in the disclosure enhancements. To the extent that the addition of disclosure enhancements, including voluntary enhancements such as SAS No. 71 reviews by independent auditors, increases the attention paid to the disclosure by those having the best opportunity to monitor the issuer on an ongoing basis, other participants in the gatekeeping process could take such efforts into account when deciding the appropriate level of due diligence needed to be performed in order to satisfy their own statutory duties, and in determining how best to satisfy those duties. ==========================================START OF PAGE 42====== The underwriter thus would continue its pivotal role in ensuring the adequacy of disclosure at the time of the offering by drawing upon all available sources of information concerning the company and assessing the scope of the ongoing reviews conducted by the other gatekeepers in evaluating the appropriate due diligence the underwriters should perform. In this fashion, the Committee has recognized both the practical demands of market participants and the need to maintain the integrity of the disclosure system. If the proposals to enhance and rationalize the due diligence process on an ongoing basis are implemented, the gatekeeping function ultimately should be more effective in protecting investors and in ensuring the integrity of corporate disclosure disseminated to the markets, not only in the context of episodic public offerings, but with respect to continuous secondary market trading as well. This principle is consistent with one of the primary motivating factors underlying a shift towards a company registration model: namely, the tremendous movement during the last few decades in investor transactions from the primary issuance markets to the secondary trading markets. Since only four to six percent of exchange and Nasdaq traded issuers make public offerings of equity in a given year,-[31]- strengthening the gatekeeping function available on a continuous basis provides greatly enhanced protection to investors overall. ---------FOOTNOTES---------- -[31]- See Figure 4 in the Addendum to Appendix A of the Report. ==========================================START OF PAGE 43====== The Committee also urges the Commission to continue exploring means to make the current liability structure more effective and more fair for gatekeepers in light of modern offering practices and techniques. After the Commission gains experience with the company registration offering process under the pilot, the Committee recommends that the Commission revisit the possibility (and the advisability) of providing more concrete guidance to various gatekeepers as to when they may be deemed to have satisfied their respective due diligence obligations. 7. Disclosure Committee In the course of its deliberations on the company registration model, the Committee considered a separate proposal to expand the role of the outside directors in ensuring the integrity of corporate disclosures.-[32]- Although not a necessary part of the company registration model developed by the Committee, the Committee strongly recommends that the Commission endorse (but not require) a new procedure whereby outside directors use the issuer's audit committee (or a separate ---------FOOTNOTES---------- -[32]- According to Professor Coffee, this concept would incorporate "the traditional reliance defense under state corporation law. Under such a rule, other outside directors could rely on a committee of directors --- tentatively called the 'disclosure committee' -- which would review the company's interim [Exchange] Act filings, such as its Form 10-K and Form 10-Q's, and consider the need for additional disclosures to cover material developments." John C. Coffee, Jr., An 'Evergreen' Company Registration Approach Would Modernize the 1933 Act, Nat'l L. J., Sept. 11, 1995, at B4. ==========================================START OF PAGE 44====== committee of one or more outside directors to be known as a "disclosure committee") to conduct an investigation of the issuer's disclosures. The Committee believes that this proposal has merit whether or not company registration is pursued by the Commission. The disclosure committee could conduct this investigation, just as a board of directors may appoint a committee to engage in other types of specialized inquiries, so long as (a) the delegating directors reasonably believe that the member(s) of the disclosure committee are sufficiently knowledgeable and capable of discharging due diligence obligations on behalf of the outside directors (if necessary, with the assistance of their professional advisers) and are provided with adequate resources to conduct the requisite investigation -- that is, the delegation must be reasonable; (b) the delegating directors maintain appropriate oversight of the disclosure committee (which would entail requiring the disclosure committee to report periodically to the Board on the procedures followed to ensure the integrity of the disclosure) and reasonably believe that the disclosure committee's procedures are adequate and were being performed; and (c) the delegating directors reasonably believe that the disclosure is not materially false or misleading. Although the reasonableness of a delegating director's reliance on the disclosure committee, as well as the director's belief in the accuracy of the disclosure based solely upon the establishment of and procedures for investigation by the ==========================================START OF PAGE 45====== disclosure committee, will depend on the facts and circumstances of each offering, the Committee believes that this practice generally will permit a delegating director to satisfy its obligations under both federal and state law.-[33]- In addressing the liability of outside directors under Section 11, the legislative history to the Securities Act states that "reliance by the fiduciary, if his reliance is reasonable in the light of all the circumstances, is a full discharge of his responsibilities."-[34]- The requirements that the delegation be reasonable and that the committee members ---------FOOTNOTES---------- -[33]- Under state law, where each director has a fiduciary duty with respect to the corporation, directors may create committees to ensure the proper functioning and discharge of their fiduciary obligations. See, e.g., 8 Del. C.  141(e) (Del. 1994); 15 Pa.C.S.A. 1712(a)(3) (Penn. 1995); American Law Institute, Principles of Corporate Governance 4.03 (1994). The legislative history of Section 11 of the Securities Act, including the 1934 amendment to the Act which deleted the original fiduciary standard and substituted a "prudent man" standard, does not suggest that Congress intended a more strict standard to apply under federal law. H.R. Rep. No. 1838, 73d Cong., 2nd Sess. 41 (1934). See James M. Landis, The Legislative History of the Securities Act of 1933, 28 Geo. Wash. L. Rev. 29, 47-48 (1959) (stating the drafter's belief that "a goodly measure of delegation was justifiable, particularly insofar as corporate directors are concerned"). -[34]- H.R. No. 152, 73d Cong., 1st Sess. at 26 (1933). See also Circumstances Affecting the Determination of What Constitutes Reasonable Investigation and Reasonable Grounds for Belief Under Section 11 of the Securities Act; Treatment of Information Incorporated by Reference Into Registration Statements, Securities Act Rel. 6335 (August 6, 1981) n. 106 [46 FR at 42022 (August 18, 1981)]. ==========================================START OF PAGE 46====== periodically report on the procedures followed in conducting the investigation,-[35]- should result in more meaningful oversight of the issuer's disclosures by its outside directors. The creation of such a voluntary committee would be consistent with current corporate governance trends emphasizing the need for outside directors to exercise continual diligence in monitoring the performance of management and ensuring the candor and completeness of company disclosures to the marketplace.-[36]- Moreover, the Commission recently underscored the critical role of corporate directors in ---------FOOTNOTES---------- -[35]- Cf. The Obligations of Underwriters, Brokers and Dealers in Distributing and Trading Securities Particularly of New High Risk Ventures, Securities Act Rel. No. 5275 (July 26, 1972) [37 FR 16011 (Aug. 19, 1972)] at text accompanying n. 29 (discussing relative responsibilities of the managing versus participating underwriters: "Thus, although the participant may delegate the performance of the investigation, he must take some steps to assure the accuracy of the statements in the registration statement. To do this, he at least should assure himself that the manager made a reasonable investigation"). -[36]- See, e.g., J. Lorsch, Empowering the Board, Harv. Bus. Rev., Jan.-Feb. 1995, at 107, 113 ("[a]udit committees made up of outside directors in all public companies ensure that financial reports are accurate, that accounting rules are followed, and that assets are not misappropriated"); F. Lippman, What Should the Audit Committee Do? 3 Corp. Gov. Adv. 22 (March/April 1995); I. Millstein, The Evolution of the Certifying Board, 48 Bus. Law. 1485 (1993). ==========================================START OF PAGE 47====== safeguarding the accuracy and integrity of a registrant's periodic reports and other public statements.-[37]- This governance mechanism would benefit investors in a variety of ways. First, it would ensure more continuous oversight of the disclosure preparation process and, over time, improve the quality and integrity of periodic and secondary market reporting and disclosure generally. Second, it will provide a focus at the board level for due diligence in the context of primary offerings by issuers, thereby ensuring greater involvement by outside directors as one set of monitors. Third, it will provide a practical means for greater outside director involvement with the due diligence activities of other gatekeepers, such as underwriters. Thus, the Committee hopes that many registered companies -- regardless of whether they are permitted to or elect to participate in the company registration system -- would choose to implement this measure as a natural extension of present "best practices" that promote investor confidence in the adequacy of corporate disclosures. The result would be an increased focus by the board on its existing statutory obligations, and additional ---------FOOTNOTES---------- -[37]- See Report of Investigation in the Matter of the Cooper Companies, Inc. as it Relates to the Conduct of Cooper's Board of Directors, Exchange Act Rel. 35082 (December 12, 1994). See also Report of Investigation in the Matter of National Telephone Co., Inc. Relating to Activities of the Outside Directors, Exchange Act Rel. 14380 (January 16, 1978). ==========================================START OF PAGE 48====== review by a qualified committee-[38]- of outside directors, while allowing the outside directors an appropriate mechanism to fulfill their Securities Act responsibilities. III. CONCLUSION The Committee believes that company registration is superior to incremental liberalization of the current offering process. Short of implementing company registration, the Commission could continue its approach of implementing incremental changes to improve seasoned issuer access to the markets, particularly through further liberalization of the shelf procedure. As noted in the description of the offering process under the company registration model, much of the suggested company registration pilot can be implemented primarily by modifying and liberalizing the shelf concept. Similarly, the Commission could take discrete steps to allow issuers to meet market demands within the framework of the current registration scheme, such as the elimination of the nonfungibility requirement of Rule 144A, the broadening of the eligibility requirements for purchasers in the Rule 144A market, the minimization of the resale limitations on restricted securities, the allowance of greater flexibility under the gun-jumping doctrine to permit "testing of the waters," and ---------FOOTNOTES---------- -[38]- Establishment of disclosure committees might also lead to the appointment of disclosure specialists (such as lawyers, accountants or bankers) to the board so that they may serve as members of the disclosure committee, just as directors are often selected based upon their qualifications to serve on audit committees. ==========================================START OF PAGE 49====== the implementation of more flexible regulatory interpretations such as those permitting A/B exchange offers. Indeed, the Committee is pleased that, since the time the Committee began its deliberations and commenced its observations on the shortcomings of the current system, the Commission has made significant proposals, and the staff has rendered interpretations, to begin to take some of these steps. The Commission's Task Force on Disclosure Simplification followed the work of the Committee and has recommended the measures crafted by the Committee to streamline further the shelf offering process.-[39]- The Task Force, however, did not make any specific recommendations for Securities Act disclosure enhancements or other measures to ensure adequate investor protections in the context of a streamlined offering process; instead it urges the Commission in implementing the streamlining recommendations to take the steps necessary to ensure quality disclosure and investor protection and points to the Committee's efforts in that regard.-[40]- ---------FOOTNOTES---------- -[39]- Report of the Task Force on Disclosure Simplification to the Securities and Exchange Commission (March 5, 1996), at 34, 38-40 (the "Task Force Report"). -[40]- As noted in the Task Force Report: The recommendations for seasoned issuers set forth under the [Task Force Report's] "Shelf Offerings" caption, as well as certain other items in this Report, are substantially identical to the streamlining concepts of the "company registration" framework developed by the Advisory Committee. Although the Task Force was not designed to overlap with the work of the (continued...) ==========================================START OF PAGE 50====== Nevertheless, continued incremental liberalization of the offering process alone would not achieve all of the benefits sought by the Committee. While such steps would benefit issuers (including those who by choice or by reason of ineligibility remain outside the company registration system), such steps ---------FOOTNOTES---------- -[40]-(...continued) Advisory Committee, the Task Force members have followed the work of the . . . Committee. The Task Force recommends almost all of the streamlining elements of company registration [e.g., eliminate restrictions on at-the-market offerings, permit an issuer to add additional securities without having to file a new registration statement, narrow the definition of affiliate, allow prospectus delivery by means of full incorporation by reference into a confirmation, and establish a pay-as-you-go fee system]. Given its original purpose, the Task Force only has sought to identify and recommend ways to streamline the regulatory process and thus only has looked at the suggestions individually. Were the Commission to reach the next step of putting the pieces together into a comprehensive package, the Task Force recommends that the Commission consider reasonably expected investor protections consequences of any particular package. The Task Force notes that the Advisory Committee has devoted significant time to deliberations on these issues as it assembled its complete [company registration] model and has added, what the Advisory Committee intends to be, significant investor protections. * * * * * The Task Force believes that the Commission, in its consideration of these recommendations [to streamline the existing shelf offering process] and any alternatives that may be suggested, should take steps to ensure that the quality of disclosure provided to investors be at least of the same quality as that provided to investors today. The Task Force notes that improving the quality of disclosures in periodic reports is an area being considered by the Advisory Committee. Id. at 34. ==========================================START OF PAGE 51====== should be balanced with increased protections for investors. Moreover, as noted in this Report, there are investor protection concerns in the current system that should be addressed before further streamlining proceeds. In addition, without a shift in the underlying regulatory philosophy, new "metaphysics" would continually be constructed to preserve the Securities Act's current transactional registration requirement. In the Committee's view, these concepts and requirements will continue to cause confusion, add substantial costs to the capital formation process, and drive issuers to alternative markets where investors will not be able to avail themselves of the protections of the Securities Act. The Committee believes that the cumulative effect of the evolutionary changes in the markets since the 1930s now requires a reassessment of the conceptual underpinnings of the regulatory process, as opposed to continued incremental changes. Company registration is consistent with the evolutionary approach of incremental liberalization, but it is also, unmistakably, a new departure. Unlike incrementalism, it says with finality that registration should not take precedence over periodic disclosure for companies that are already traded. It recognizes and addresses what was not yet apparent in the early 1930s: the economic importance of traded companies raising additional capital by issuing securities. Thus company registration is far more than a cost-reduction and efficiency reform. It is a new beginning for the registration process, and it is overdue. The ==========================================START OF PAGE 52====== shift to a company registration system thus would change the way we think about the regulation of the capital formation process and foster a fresh approach to addressing the various problems. This more comprehensive conceptual approach would address both the interests of seasoned issuers in today's fast-moving markets, and the implications of those changes in the markets and offering processes for investors, underwriters, and other participants. The company registration pilot described in this Report continues the process of using the Commission's existing rulemaking authority to effect appropriate reforms, rather than recommending major legislative changes. The Committee decided at the outset, at the urging of Chairman Levitt and Commissioner Wallman, to promote primarily those modifications that could be accomplished, at least initially, through rulemaking as opposed to legislation. The benefit of this approach is that it provides greater flexibility for Commission experimentation and timely regulatory adjustments as dictated by experience with the pilot. While some of the complexity and various aspects of the pilot are necessary in order to fit within the current regulatory scheme and would be unnecessary under a legislatively implemented system, experience gained under the pilot will provide a firm foundation for determining what legislative changes and/or rulemaking changes, if any, would be appropriate to simplify further the regulatory process and complete the long-awaited transition to a company registration system. ==========================================START OF PAGE 53====== IV. SEPARATE STATEMENT OF JOHN C. COFFEE, JR., EDWARD F. GREENE, AND LAWRENCE W. SONSINI We write separately, not to criticize the Advisory Committee's Report (with which we fully concur), but to voice our concerns that additional steps must be taken by the SEC to fully realize the Report's goals and to stress the need for any specific reforms adopted based on this Report to be consistent with the integrated approach taken by this Report, which seeks to pursue both deregulation and qualitative improvement in our disclosure system. Achieving one without the other will not be an advance. Essentially, we advance two basic contentions: (1) The transition from the transaction-oriented disclosure system of the past to the company registration system envisioned herein must be accompanied by a corresponding transition in liability rules. Otherwise, there is a fundamental incongruence between what can realistically be expected of the independent "gatekeepers" (outside directors, accountants, underwriters and others) who monitor the corporation's disclosures and their statutory responsibilities under the Securities Act of 1933. In particular, we are skeptical that practitioners will recommend, or that corporations will adopt, some of the reforms that this Report proposes (such as, in particular, the disclosure committee) without further guidance from the Commission. In particular, some form of safe harbor must be developed that protects disinterested persons who undertake ==========================================START OF PAGE 54====== due diligence efforts under company registration from thereby effectively incurring insurer-like liability for the accuracy of all factual information incorporated into the registration statement. (2) The incentives to opt into a company registration system are uncertain and limited. Some companies may prefer to rely on the existing shelf registration system. In our judgment, it is unwise to have two parallel systems, one carrying the obligation to file a mandatory Form 8-K at the time of a substantial equity issuance plus requirements for certification by top management and the preparation of a senior management report; and the other, not. Any disparity between company registration and shelf registration that requires mandatory filings, certifications, and reports under the former (but not the latter) will create an unfortunate and powerful incentive for issuers to opt to remain within the existing shelf registration system. Thus, we would urge the Commission to adopt similar requirements with respect to the existing shelf registration system. More generally, our concern is that pressures may develop for the Commission to adopt selectively the deregulatory proposals from this Report while quietly ignoring the disclosure enhancements and supplemental filing obligations that this Report also envisions. The proposals in this Report are part of a balanced and integrated package, which should not be implemented on a piecemeal basis. ==========================================START OF PAGE 55====== 1. Due Diligence Under Company Registration Model and the Problem of Liability. We share the view clearly stated in this Report that company registration has not made, and should not make, obsolete the efforts of the corporation's independent "gatekeepers" (i.e., its outside directors, accountants, and underwriters) to verify and monitor the accuracy of the corporation's disclosures. No less than our colleagues on the committee, we believe such due diligence efforts play a critical role in assuring the integrity of our disclosure system. But the advent of company registration (as the culmination of a shelf registration system that has efficiently evolved over time so as to assure issuers increasingly rapid market access) does require that we rethink how due diligence is undertaken and the level of liability that can be fairly attached to it. In the past, concern has been expressed that the rapid pace and time constraints associated with shelf registration makes due diligence infeasible.-[1]- Although the available evidence remains largely anecdotal, we recognize that such a tendency may exist and could accelerate under a company registration system. The Report directly addresses this problem by recommending a mandatory Form 8-K filing at the time of any substantial equity issuance (i.e., greater than 3% of outstanding shares). As ---------FOOTNOTES---------- -[1]- Compare Merritt Fox, Shelf Registration, Integrated Disclosure, and Underwriter Due Diligence: An Economic Analysis, 70 Va. L. Rev. 1005 (1984) and David Green, Due Diligence Under Rule 415 Is the Insurance Worth the Premium?, 38 Emory L.J. 793 (1989). ==========================================START OF PAGE 56====== strong proponents of such a requirement, we believe that one of its most important virtues is that it may provide a focal point for due diligence.-[2]- Because a Form 8-K carries Section 11 liability (unlike a prospectus supplement), we expect that participating underwriters, the company's senior management, and its accountants would meet to discuss and review the contents of the proposed Form 8-K and recent developments during the current quarter.-[3]- The existence of a mandatory filing requirement may strengthen (perhaps only marginally) the position of the underwriters in their negotiations with management over the conduct of due diligence.-[4]- On balance, we believe ---------FOOTNOTES---------- -[2]- Such due diligence would chiefly focus on whether material developments had occurred since the date of the corporation's last filing under the 1934 Act's continuous disclosure system. We do not mean to imply that verification of prior filings would necessarily be undertaken at such issuance. -[3]- Indeed, some recent decisions suggest that the failure to implement such a review for late- breaking developments may subject the corporation and its directors to liability under 11 because the registration statement and prospectus may as a result contain material omissions. See Shaw v. Digital Equipment Corp., 83 F.3d 1194 (1st Cir. 1996) (where offering under a shelf registration statement occurred near end of quarter, the failure to disclose downturn during current quarter that was below analyst forecasts could constitute a material omission for purposes of 11 of the Securities Act of 1933). -[4]- In discussions we have had both within the Advisory Committee and with underwriters and others, this proposal has been described as the "Form 8-K speed bump." This may mischaracterize it. Like a speed bump, it does require the issuer to focus and pay attention to this filing obligation, but it does not require any necessary (continued...) ==========================================START OF PAGE 57====== that such a requirement will better protect the interests of investors at relatively low cost to issuers. But here difficulties surface that motivate us to write separately. To the extent that company registration is adopted (or that any significant step is taken toward simplifying the existing system of shelf registration), corporate issuers may come to make more frequent use of the debt and equity markets.-[5]- Issuers seeking to make frequent use of company registration (or the existing shelf registration system) face a problem, because repetitive debt or equity offerings co- exist uneasily at best with the statutory structure of the Securities Act of 1933. By regularly tapping the capital markets through repetitive offerings, the corporation exposes its directors to an increased risk of 11 liability under circumstances that make effective compliance with their statutory "due diligence" defenses infeasible. Although we have no doubt that the board should familiarize itself with the contents of the registration statement in the context of a major public offering, there is not the same opportunity for factual verification and searching questioning in the context of smaller, repetitive ---------FOOTNOTES---------- -[4]-(...continued) braking in the issuance process. -[5]- If it occurs, such an evolution toward smaller, more frequent offerings could efficiently reduce the cost of capital to corporate issuers and might even parallel the "just-in-time" supply systems that American issuers have begun to copy from their Japanese originators. ==========================================START OF PAGE 58====== offerings. Nor is it necessarily efficient to consume the board's limited time in this fashion. The dilemma then is that either (1) board members are over-exposed to liability because they cannot establish their due diligence defenses within these compressed time frames, or (2) the corporation must forgo repetitive offerings because of the legal risks to its directors. Neither option is attractive; nor is this choice necessary. This example illustrates a more general point: "company registration" represents a movement away from a transaction- oriented system of disclosure. But the liability rules of the Securities Act of 1933 remain transaction-oriented. As a result, a mismatch arises, which, we submit, requires that the liability provisions of the federal securities laws also be re-assessed. Of course, such an undertaking invites some controversy, but it is today a feasible project now that the Private Securities Litigation Reform Act of 1995 has given the Commission broad exemptive authority under both the Securities Act of 1933 and the Securities Exchange Act of 1934.-[6]- ---------FOOTNOTES---------- -[6]- See Section 27A(g) of the Securities Act of 1933, 15 U.S.C. 77z-2(g), and Section 21E(g) of the Securities Exchange Act of 1934, 15 U.S.C. 78u- 5(g). We are, of course, aware that the Commission has not yet spoken to the scope of its exemptive authority under these sections. We believe, however, that courts would defer to any "reasonable" construction of these provisions advanced by the Commission. See Chevron U.S.A. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). The pending Securities Investment Promotion Act of 1996 would also greatly enhance the Commission's exemptive authority in even clearer statutory language. ==========================================START OF PAGE 59====== How might the liability provisions of the Securities Act of 1933 be modified? Less we be misunderstood, we stress at the outset that we do not seek to abolish liability under 11 or 12. Although there are multiple forces that drive our disclosure system, the risk of liability is one of the most significant, and it motivates independent gatekeepers to test and, if necessary, challenge the issuer's proposed disclosure. The proposed Form 8- K requirement (which we support) at least technically increases the risk of 11 liability for both board members and underwriters.-[7]- In seeking to strike the proper balance, we believe the proper starting point is to define a realistic role for gatekeepers that is sensitive to both the time constraints imposed on issuers and underwriters by the marketplace and the character of the modern board of directors. When the Securities Act of 1933 was drafted, both were very different. Corporate boards were then insider-dominated with few truly independent directors, and as a result it was natural to assume that board members would be familiar with all material pending corporate developments. The modern board is now predominantly composed of outside directors, who are not necessarily familiar on a daily basis with all material information concerning their corporation ---------FOOTNOTES---------- -[7]- On the other hand, fulfillment of this duty may serve to protect directors and underwriters from liability for material omissions relating to developments subsequent to the issuer's last Form 10-Q. See Shaw v. Digital Equipment Corp., supra n.3. ==========================================START OF PAGE 60====== and who have other commitments and business obligations that preclude them from devoting unlimited time to the corporations they serve as outside directors. Correspondingly, where once a public offering of debt or equity securities was a long, drawn- out process which permitted ample time for conducting a due diligence review, it can now occur from conception to consummation under shelf registration within the space of a single day. As a result, the full board of directors, dispersed in the typical case across the country and subject to their own time constraints, often cannot undertake a meaningful due diligence review, at least not within the compressed time frames that the equity marketplace imposes. What then can be done without sacrificing the idea of independent gatekeepers? The modern board necessarily functions through specialization and delegation. Thus, one of us has recommended (and the Advisory Committee has accepted) the idea of a disclosure committee in which the "due diligence" gatekeeping function would be largely centralized. Such a committee, which would in all likelihood be a subcommittee of the audit committee, would meet with the underwriters, senior management, and the outside accountants to review the corporation's disclosures and its proposed Form 8-K. Directors not on this committee would be entitled to rely on the efforts of such a committee (at least provided that their reliance was reasonable and they did not have any objective reason to doubt its performance and did not ==========================================START OF PAGE 61====== otherwise lack confidence in the accuracy of the corporation's disclosures or financial statements). Even if the logic of our proposal is sound, movement toward it will not come automatically. Rather, the Commission must hold out positive incentives to encourage its adoption. Here, the Report stops short of addressing these necessary incentives. One such incentive would be a clear right on the part of the other directors to rely on such a committee, much as directors may do under the common law or statutory provisions in most states. Even more importantly, however, the SEC would need to face and address the liability of the disclosure committee members, themselves. Easy as it is to say that the rest of the board can rely upon the disclosure committee, this policy will not work if outside directors are unwilling to staff such a committee for fear of enhanced liability. As a practical matter, we doubt that practitioners will counsel directors to adopt such a committee or to serve on it -- absent clearer SEC guidance.-[8]- Such SEC guidance could take a variety of forms: safe harbors, a burden shifting rule, or some fuller specification of what the committee should do. For example, when the disclosure committee has engaged in a specified review of the corporation's financial ---------FOOTNOTES---------- -[8]- Indeed, the early commentary on a publicly circulated draft of this Report has focused on exactly this problem. See Roberta S. Karmel, Deregulation: Real or Alleged, N.Y.L.J., June 20, 1996, at 3, 7 (noting that "there would be no diminution in 11 liability under the Securities Act . . ." under the Advisory Committee Report). ==========================================START OF PAGE 62====== statements and '34 Act filings, the Commission might exercise its exemptive authority to shift the burden of proof under 11 to the plaintiff to prove that this investigation was inadequate. Such a change would not wholly absolve committee members from liability, but it would require the plaintiffs to prove by clear and convincing evidence that the investigation that they did conduct was unreasonable under the circumstances. Beyond this change, a more general principle might also be recognized: the diligence that is due should be proportionate to the size and character of the offering. Today, the leading precedents that guide practitioners -- Feit v. Leasco Data Processing Equip. Corp.,-[9]- and Escott v. Bar Chris Construction Corp.-[10]- -- deal with major offerings by high-risk companies. These cases are clearly correct on their facts, but they do not address the nature of the investigation that should be required by outside directors or underwriters in proportionately smaller offerings by established companies with rapid access to the market under a company registration system in order to establish a "reasonable investigation" defense under 11. Here again, SEC guidance is necessary if the board and the underwriters are to play a meaningful role as a gatekeeper in the disclosure process. ---------FOOTNOTES---------- -[9]- 332 F. Supp. 544 (E.D.N.Y. 1971). -[10]- 283 F. Supp. 643 (S.D.N.Y. 1968). ==========================================START OF PAGE 63====== We, of course, recognize that a single Advisory Committee cannot address every issue, and this committee was not selected to address legal issues. Nonetheless, the Report concludes without proposing ways to update the liability rules under the federal securities laws to mesh with its proposed new disclosure system. As a result, the paradigm shift that this Report envisions is incompletely articulated. Gatekeeper liability makes sense only when the gatekeeper is placed in a position to take effective preventive action. Strategies such as the disclosure committee may enable a board committee to play a meaningful gatekeeper role in the disclosure process. But, to induce the corporation to form such a committee or outside directors to staff it, some relief from the "in terrorem" liabilities of 11 is necessary. In the last analysis, a choice must be made between (1) abandoning the idea of a gatekeeper role for the outside director (as some have argued)-[11]- and (2) focusing the liability provisions of the federal securities laws so they encourage the performance of clearly specified responsibilities, but expose the board to no greater liability than is necessary. That choice has not yet been made and now falls to the Commission. (2) Adopting Company Registration Via the Backdoor. We are concerned that the recommendations of the Advisory Committee could be adopted in a selective, piecemeal fashion that ---------FOOTNOTES---------- -[11]- See, e.g., Green, supra n.1. ==========================================START OF PAGE 64====== yields greater deregulation but little or no qualitative improvement in our disclosure system. If there were to be significant deregulation of the existing shelf registration system without the concomitant adoption of mandatory disclosure enhancements or the proposed Form 8-K filing obligation, this would be the net result. Even if company registration is adopted as a voluntary opt- in system, there may be inadequate incentives for issuers to elect it. Inevitably, issuers will compare company registration with shelf registration. Here, one of the principal attractions of company registration over shelf registration is that it gives the issuer greater flexibility by permitting the issuer in effect to register and sell all its outstanding shares without substantive restrictions. In contrast, Rule 415 permits a shelf registration statement in the case of an "at the market offering of equity securities" to register no more that "10% of the aggregate market value of the registrant's outstanding voting stock held by non-affiliates of the registrant."-[12]- Although this limitation seems significant at first glance, the staff's interpretation of this provision has minimized its actual impact. For example, we have been informed by the staff that it does not read the 10% ceiling on shelf registration to apply to a fixed commitment underwriting, even when the offering is done at the last closing price of the issuer's stock on a stock exchange. ---------FOOTNOTES---------- -[12]- See Rule 415(a)(4)(ii), 17 C.F.R. 230.415(a)(4)(ii). ==========================================START OF PAGE 65====== In such a case, we were told, the offering will not be deemed an "at the market" offering. As a result, the relative incentive to opt into a voluntary company registration system dissipates to the extent this ceiling on shelf registration is relaxed. Indeed, while an offering under company registration will sometimes be subject to staff review (if it is in excess of a specified percentage of the company's outstanding shares), no such review will occur under the current system if the offering is properly structured and the company has filed an unallocated shelf registration statement.-[13]- We point to this example not to protest it, but simply to illustrate how weak the incentives may be to elect into a voluntary company registration system, especially in light of the growing use of unallocated shelf registration statements. In contrast, the regulatory requirements associated with company registration are real. Chief among these are the mandatory Form 8-K filing obligation, the certification requirement, and the senior management report. Although the Form 8-K filing may serve to promote a current review of developments subsequent to the corporate issuer's last filing under the Securities Exchange Act of 1934's periodic disclosure system (and ---------FOOTNOTES---------- -[13]- If the Commission adopts its proposed rule to make reporting of probable and material acquisitions the same under the Securities Act of 1933 and the Securities Exchange Act of 1934, an unallocated shelf registration statement will seemingly give more predictable market access than would be available under company registration. ==========================================START OF PAGE 66====== this could reduce corporate liability), it is undeniable that many issuers will view this requirement (and the other new mandatory features associated with company registration) as increased burdens, particularly because any periodic report that is incorporated by reference into the registration statement will carry 11 liability. In contrast, a prospectus supplement does not carry 11 liability (nor will it create 12(2) liability for the corporation's directors because they are not in privity with the buyers). Hence, this disparity between the legal status of a Form 8-K filing and a prospectus supplement may cause corporate counsel to prefer shelf registration to company registration. We see only one answer to this problem: level the playing field by extending the new requirements to shelf registration as well.-[14]- In our judgment, these requirements are justified because they should enhance the quality of disclosure to the secondary market. We realize that this proposal will not be popular in some quarters. Still, unless it is implemented, the prospect is remote in our judgment that many issuers will adopt company registration. ---------FOOTNOTES---------- -[14]- We recognize that the Advisory Committee Report does recommend that the Form 8-K filing obligation be extended to shelf registration as well as to company registration, but we are concerned that, unless highlighted, this recommendation may receive inadequate attention. ==========================================START OF PAGE 1====== APPENDIX A THE IMPACT OF THE CURRENT REGULATORY SYSTEM ON INVESTOR PROTECTION AND CAPITAL FORMATION I. Introduction . . . . . . . . . . . . . . . . . . . . . . . II. Direct and Indirect Costs and Uncertainties Resulting From the Registration Process for Public Offerings . . . . . . . A. Costs of Registration - The Offering Process . . . 1. Direct Costs Associated with the Public Offering Process 2. Delay and Uncertainty Caused by Commission Staff Review 3. Residual Costs Associated With Registering Equity Securities On Shelf Registration Statements -- Pre-offering Filing Fees, Short-Selling and Market Overhang . . . . . . . . . . . . . . . . . B. Indirect Costs Associated with the Current Regulatory Scheme . . . . . . . . . . . . . . . . . . . . . . . 1. Securities Act Concepts Designed to Ensure the Registration of Public Offers and Sales Can Produce Unnecessary Costs and Uncertainties and Reduce Flexibility in Structuring Financing Transactions . . . . . . . . . . . . . . ù Gun-jumping . . . . . . . . . . . . . . . . . ù Integration and General Solicitation Doctrines . . . . . . . . . . . . . . . . . . ù Constraints on Resales - Statutory Underwriters and Affiliates . . . . . . . 2. Mandatory Prospectus Disclosure Requirements Do Not Meet Investor Needs in the Most Efficient Manner . . . . . III. Changes in the Markets and Offering Processes, and the Effect on Investor Protection . . . . . . . . . . . . A. Attractiveness of Public, Private and Offshore Markets ==========================================START OF PAGE 2====== B. Blurring of Distinctions Between Public, Private and Offshore Markets . . . . . . . . . . . . . . . . . . . C. Growth of Secondary Markets and Changes in Offering Techniques . . . . . . . . . . . . . . . . . . . . D. Changes in Gatekeeper Role . . . . . . . . . . . . . . . . ADDENDUMS TO APPENDIX A Figure 1: Aggregate Net Issuance of Securities by Domestic Non- Financial Businesses, by Year Figure 2: Total Value of Public Offerings of Equity vs. Trading Volume in Existing Markets, by Year Figure 3: Value of Underwritten Public Offerings and Private Placements of Equity, by Year Figure 4: Percent of Issuers Offering Additional Common Stock, by Year and Type of Filing Figure 5: Distribution of Waiting Periods, by Review, for Offers of Additional Common Stock, 1990-94 Figure 6: Fraction of Offers Within Various Size Limits, for Underwritten Offers of Common Stock, 1992-94 List of Tables Table 1 Typical Expenses In Underwritten Public Offers of Common Stock in 1993-95 Table 1b Typical Expenses in Underwritten Public Offers of Common Stock in 1993-95, for Repeat Offers of $20 to $200 million by Domestic Issuers, by Value of Offer Table 2 Typical Experience of Filers of Registration Statements for Underwritten Public Offers of Common Stock, January 1994 through December 1995 Table 3 Typical Change in Stock Price from Filing to Effective Date, for Underwritten Public Offers of Additional Common Stock by 990 NYSE/Amex/Nasdaq issuers, 1993-94, by Pre-Offer Market Capitalization, and by Whether the Filing is Reviewed by the SEC ==========================================START OF PAGE 3====== Table 4 Relative Importance of Shelf Registration as a Vehicle for Securities Sales, by Class of Security and Year APPENDIX A THE IMPACT OF THE CURRENT REGULATORY SYSTEM ON INVESTOR PROTECTION AND CAPITAL FORMATION I. Introduction The Committee, in the course of its deliberations, identified costs associated with the current regulatory process and disclosure requirements relating to public offerings of securities, secondary market trading and corporate reporting. The Committee then investigated the extent to which the benefits derived from the existing regulatory structure continue to justify the identified costs. Although significant progress has been made by the Commission over time to streamline the capital formation process, particularly through the adoption of the integrated disclosure system and shelf registration, domestic capital formation through public securities offerings continues to be hampered by costs and uncertainties associated with the registration process. These costs include both direct and indirect costs created by the registration process, including costs resulting from the increasingly complex, and often ambiguous, legal distinctions that have evolved to protect that process. The current regulatory system crafted during the era of the Great Depression does not fully and most efficiently meet the needs and realities of today's markets, which are increasingly complicated by modern financing techniques, technological advancements, globalization, and changes in investor profiles and demands. These developments bring into question whether all ==========================================START OF PAGE 2====== types of companies should be subject to the current Securities Act's transactional registration requirements each time they desire to raise capital in the public markets. After concluding that the current structure was imposing unnecessary costs, while not fully taking into account the needs of today's investors, the Committee determined to recommend a shift in the focus of the regulatory structure from the current transactional system to a company registration system that would reduce these costs while enhancing investor protection. II. Direct and Indirect Costs and Uncertainties Resulting From the Registration Process for Public Offerings The current registration scheme imposes indirect and direct costs. The indirect costs include uncertainty and delay arising from the possibility of Commission staff review (including the possibility of losing a market window), market overhangs, short-selling and related activities, and publicity constraints. Direct costs include legal, accounting, underwriting, printing and filing fees. A. Costs of Registration - The Offering Process 1. Direct Costs Associated with the Public Offering Process The public offering process can be costly for issuers. For smaller companies and newer entrants to the capital markets, the fees paid to the Commission, state regulators, accountants, lawyers, underwriters, and financial printers amount to a larger percentage of offering proceeds than for more seasoned issuers. However, the absolute amount of these direct costs also can be significant for more seasoned issuers. Generally, direct costs are higher for offerings of common stock compared to bonds. From January 1990 through December 1994, it is estimated that the ==========================================START OF PAGE 3====== direct costs of raising capital in public offerings averaged 2.2% of proceeds for straight debt, 3.8% for convertible bonds, 7.1% for repeat offerings of equity by seasoned issuers, and 11.0% for initial public offerings of equity.-[1]- Table 1 below, prepared by the Committee staff, shows the breakdown of the components of the direct costs of public offerings, focusing on offerings of common stock from January 1993 to December 1995. Underwriter's compensation (spread) is the largest component of floatation costs, typically amounting to 5.3% of proceeds in repeat offerings and 7% of proceeds in initial public offerings. Systematic underpricing, as measured by the discount from market price, constitutes the second largest component, typically amounting to 1.2% of proceeds in repeat offerings and 7.1% in initial public offerings. Summing these costs and all other direct fees (for lawyers, accountants, printers, and regulators), the total cost of raising capital through public offerings of common stock typically amounts to 7.3% of proceeds in repeat public offerings and 16.9% in initial public offerings. Table 1 also provides data on floatation costs broken down according to the type of filing used to register the stock, and shows that typical costs are lowest for issuers using Form S-3 shelf offerings (5.0%) and highest (almost 20 - 30%) among the small-business filers that use Form ---------FOOTNOTES---------- -[1]- Inmoo Lee, Scott Lockhead, Jay Ritter and Quanshui Zhao, The Costs of Raising Capital, Journal of Financial Research, Vol. XIX, No. 1, pp. 59-74 (Spring 1996). ==========================================START OF PAGE 4====== SB-2.-[2]- ---------FOOTNOTES---------- -[2]- Form SB-2 is a short-form registration statement available to small businesses. One reason, seen in Table 1, that the offering costs for SB-2 filers is a higher proportion of proceeds is that the typical SB-2 offer yields just $6 million in proceeds, compared to $78 million for shelf offerings. ==========================================START OF PAGE 5====== __________________________________________________________________________________________ Table 1 Typical Expenses In Underwritten Public Offers of Common Stock in 1993-95 Registration Number Median Median Median Median Sum Form Used Value Under- Fees Discount of writer (a) Offer Spread from (millions Market dollars) Price (b) Initial SB-2 408 $6.1 10.0% 7.4% 11.5% 28.9% Offer of Common Stock by Domestic Issuer S-1 1201 30.1 7.0 2.3 7.1 16.4 S-2, S-11 100 131.7 6.5 1.8 1.1 9.4 Sub-Total 1709 24.0 7.0 2.8 7.1 16.9 Repeat SB-2 99 7.9 9.0 4.5 5.4 18.9 Offer of Common Stock by Domestic Issuer S-1 468 32.0 5.5 1.3 2.4 9.2 S-2, S-11 192 20.4 6.0 1.7 2.3 10.0 S-3, Non- 751 59.1 5.0 0.6 0.7 6.3 shelf S-3, Shelf 136 77.6 4.6 0.4 0.0 5.0 (c) Sub-Total 1646 44.8 5.3 0.8 1.2 7.3 Overseas F-1, F-2, 214 65.1 5.1 2.1 1.3 8.5 Issuer F-3 Total 3569 $32.5 6.8% 1.8% 2.8% 11.4% Source: Securities Data Corp. Includes firm commitment underwriting only. Notes: (a) Fees include SEC and state filing fees, listing fees, legal fees, accounting fees, printing costs, and other miscellaneous fees. (b) The discount from market captures underpricing of offers, measured here by the first-day return, calculated as the percentage change from the offer price to the market price at the close of trading on the offer date. (c) Since there can be multiple offers (takedowns) from shelf registrations, calculations for this category are based on the first takedown of common stock. __________________________________________________________________________________________ Table 1b Typical Expenses In Underwritten Public Offers of Common Stock in 1993-95, for Repeat Offers of $20 to $200 million by Domestic Issuers, by Value of Offer Value Registration Number Median Median Median Median Sum of Offer Form Used Value Under- Fees Discount (million of writer (a) dollars) Offer Spread from (millions Market dollars) Price (b) $20.0 S-1 167 $32.4 5.5% 1.2% 2.3% 9.0% to $49.9 S-3, Non-Shelf 226 34.7 5.5 0.8 1.2 7.5 S-3, Shelf 28 33.8 5.0 0.7 0.0 5.7 $50.0 S-1 99 62.1 5.0 0.7 1.1 6.8 to $99.9 S-3, Non-Shelf 250 66.9 5.0 0.5 0.7 6.2 S-3, Shelf 49 72.2 5.3 0.5 0.0 5.8 $100.0 S-1 31 125.9 4.5 0.3 1.4 6.2 to $199.9 S-3, Non-Shelf 135 128.1 4.0 0.3 0.5 4.8 S-3, Shelf 30 130.8 3.5 0.3 0.0 3.8 Source: Securities Data Corp. Includes firm commitment underwriting only. Notes: (a) Fees include SEC and state filing fees, listing fees, legal fees, accounting fees, printing costs, and other miscellaneous fees. (b) The discount from market captures underpricing of offers, measured here by the first-day return, calculated as the percentage change from the offer price to the market price at the close of trading on the offer date. Floatation costs are higher for small business issuers for reasons unrelated to regulation, but a differential regulatory ==========================================START OF PAGE 6====== burden is the best explanation for the lower floatation costs experienced by S-3 issuers as compared to S-1 issuers. For repeat offerings of common stock by seasoned issuers, S-1 issuers incur costs totalling approximately 9.2% of proceeds, whereas S-3 (non-shelf) issuers incur costs totalling approximately 6.3% of proceeds, and S-3 (shelf) issuers incur costs totalling 5.0% of proceeds. These differences are only partly attributable to the larger offer size seen in offerings on Form S-3. Table 1b below reports typical offering costs for various sized offers, and a pattern of lower costs for offerings utilizing Form S-3 is found within each size-based subgroup. Table 1b - see accompanying link ==========================================START OF PAGE 7====== The single largest determinant of the lower costs seen in the S-3 shelf filings is the ability to distribute the securities at the current market price upon takedown, rather than at a discount to the market price as seen in offerings utilizing Form S-1 or Form S-3 non-shelf. These cost savings are indicative of the benefits of "just-in-time" financing techniques that would be available to company-registered issuers. It is the Committee's hope and expectation that an increase in an issuer's flexibility to go to market in a more streamlined manner could result in further reductions in the direct costs of public offerings. Lower direct costs could translate into lower costs of capital in numerous ways. Allowing for the adoption of just-in-time capital techniques, whereby companies can access the market exactly when they want and for the exact amount they want, will help eliminate the discount from the market price currently experienced in non- shelf public offerings of common stock. In addition, by extending the benefits of the streamlined offering process and creating greater flexibility regarding the delivery of disclosure documents to investors, underwriting, legal and printing costs should be reduced further. ==========================================START OF PAGE 8====== 2. Delay and Uncertainty Caused by Commission Staff Review The time consumed by the registration process represents an indirect cost for issuers. Under the current system, no sales of securities are allowed until the Commission has declared a registration statement to be effective. During this waiting period, the length of which may be affected by whether the Commission staff reviews the document, issuers may miss a desired market window. Under the current Commission staff's selective review criteria, all registration statements for initial public offerings (IPOs) are reviewed by the staff. In addition, pursuant to internal selective review criteria, the staff may choose to review any other registration statement filed with the Commission, including shelf registration statements when initially filed to register securities for the shelf. Prior to filing a registration statement, even the most seasoned issuer will not know whether its registration statement will be reviewed, or the length of the time delay resulting from the review process if there is a staff review. Issuers trying to sell securities, other than off a shelf registration statement previously declared effective, consequently cannot predict in advance exactly when they will be able to go to market.-[3]- ---------FOOTNOTES---------- -[3]- For shelf offerings, the shelf registration statement may not be used until declared effective by the staff. And, as a practical matter, most initial takedowns off a shelf occur shortly after (continued...) ==========================================START OF PAGE 9====== Often, they will prepare two different time schedules when planning a public offering -- one assuming Commission review, and the other assuming no review -- and the difference between these two timetables can be substantial.-[4]- If a registration statement is reviewed, the staff does not comment on the merits of an offering. Rather, the staff evaluates the adequacy of the issuer's disclosures. Staff review encompasses the disclosure in the registration statement as well as in the company's Exchange Act reports and any other documents on file with the Commission. Under shelf registration, however, the staff does not review prior to its use the prospectus supplement containing transactional information that is used in taking down securities off the shelf for public sale. After receiving staff comments, issuers may respond to the issues raised in the comment letter by revising disclosures in the registration statement and other corporate disclosures (including possibly Exchange Act reports) to address the staff's concerns, by explaining in a supplemental letter to the staff why ---------FOOTNOTES---------- -[3]-(...continued) the registration statement becomes effective. Thus, the staff review process may still pose a real impediment to shelf takedowns. However, because the issuer may register up to the amount of securities that it expects to issue in the next two years, and there generally is no post- effective staff review of takedown prospectuses, theoretically this delay does not have to occur frequently. -[4]- Transcript of May 8, 1995 Advisory Committee Meeting at 227 (statement of Gerald Backman). ==========================================START OF PAGE 10====== revisions are not necessary, or both. After the issuer resolves the concerns raised by the staff, the registration statement is declared effective. In the extreme, where an issuer misses a market opportunity while responding to the staff's inquiries, the company will have expended significant funds preparing for an unsuccessful offering (although, for a shelf issuer where registration statement has been declared effective, the issuer can use the effective shelf at a subsequent time). The mere prospect of such uncertainty and delay may cause an issuer to forego a registered offering. Table 2 below provides a Committee staff analysis of recent issuer experience with staff review, covering the frequency of review and the average length of waiting periods. These results are given for registration statements of underwritten offerings of common stock that were declared effective during 1994 and 1995. During that period, all initial public offerings received a full review. In addition, pursuant to selective review, less than one in six Form S-3 shelf and non-shelf registration statements were reviewed, and approximately one-third of all other registration statements for repeat offerings were reviewed. ==========================================START OF PAGE 11====== Table 2 Typical Experience of Filers of Registration Statements for Underwritten Public Offers of Common Stock, January 1994 through December 1995 Registration Number Average Average Number of Percent Average Form Used Amount Days before Reviewed Number Registered Effective: by SEC of times ($millions) Amended Spent Spent Total at at the the Issuer SEC Initial SB-1 & 122 $20.3 42.6 61.1 103.7 100% 3.3 Offer of SB-2 Common Stock by Domestic Issuer S-1 641 66.4 38.9 39.3 78.1 100 3.2 S-11 42 198.8 45.5 60.0 105.5 100 4.0 Repeat SB-2 64 24.2 23.8 44.5 68.2 54.7 2.4 Offer of Common Stock by Domestic Issuer S-1 310 70.3 16.7 35.4 52.2 33.5 1.8 S-2, S-11 79 67.7 15.6 36.5 52.2 24.1 1.9 S-3, Non- 416 111.1 9.3 22.8 32.1 13.9 1.2 Shelf S-3, Shelf* 486 284.1 17.5 36.3 53.7 16.0 1.1 Foreign F-1, F-2, 117 205.4 17.0 45.3 62.4 78.6 2.4 Issuer F-3 Source: SEC Division of Corporation Finance. Includes firm commitment underwriting only. Excludes regional office filings. * Includes shelf offerings of common stock by the issuer and unallocated shelf offerings that are not exclusively debt and/or preferred stock; does not include Commission staff pre-review -- which is never done -- of the takedown prospectus; with regard to shelf registration statements, staff review is limited to the registration statement when initially filed. The typical time period between the filing and the effectiveness of the registration statement was less than three months for an initial public offering and less than two months for repeat offerings. Waiting periods may be longer when the staff's review and comments are extensive and require substantial ==========================================START OF PAGE 12====== revisions to the registration statement before being declared effective, thereby introducing uncertainty into the capital formation process. Staff review also reduces the predictability of waiting periods, i.e., the length of the waiting period will vary more where the document is reviewed than when not reviewed. The degree to which waiting periods vary in length is illustrated in Figure 5 in the Addendum to this Appendix A, which is a histogram showing the relative frequency with which waiting periods of various lengths were observed among underwritten offers of additional common stock during 1993 and 1994. As shown in Figure 5, the distribution of the length of waiting periods is more tightly clustered around the average waiting period in the absence of a staff review. The length of the waiting period also is influenced significantly, however, by factors separate from the Commission review procedure, such as whether the disclosure in the registration statement when initially filed was significantly deficient, whether the issuer delayed or significantly altered the structure of the financing after the registration statement was filed, and whether the issuer's Exchange Act reports had been recently reviewed by the staff.-[5]- ---------FOOTNOTES---------- -[5]- Even if a document is not reviewed by the Commission staff, issuers can and do amend registration statements prior to effectiveness. On average, non-shelf registration statements that are not reviewed are amended at least once prior to effectiveness (compared to approximately three amendments if reviewed). Although shelf registration statements are amended less often (continued...) ==========================================START OF PAGE 13====== The risk that disclosed information is erroneous, incomplete or fraudulent is itself a significant uncertainty that can impose costs on the capital formation process. Thus, a potential benefit of the retention of Commission review of transactional disclosure documents arises from efforts by the Commission staff to compel issuers to disclose more fully information that would impact market perceptions of the value of the securities to be issued. The Committee strongly believes that staff review is important where the transaction involves IPOs or major restructurings. In these cases, the issuer in essence is beginning the disclosure process anew because the bulk of the information already available to the public, if any, is not as useful as in the case of a seasoned company doing a routine financing. In addition, the coverage by analysts and the efficiency of the markets in reviewing and absorbing the information and in pricing securities is less effective in these transactions than with routine repeat offerings by seasoned companies. By retaining staff review in these instances, corrective revisions of preliminary prospectuses prior to closing can enhance the quality of the disclosure provided to investors, ---------FOOTNOTES---------- -[5]-(...continued) than non-shelf registration statements after filing with the Commission, non-reviewed shelf registration statements are amended prior to effectiveness .5 times versus 2.4 times for reviewed shelf registration statements (although presumably some of these amendments in the latter category are voluntary). ==========================================START OF PAGE 14====== prevent later and more disruptive corrective disclosure, and reduce an issuer's exposure to litigation. In the case of Form S-3 eligible issuers doing routine offerings, however, where the market following these issuers is better informed and efficient, the benefits of any review process obviously are less certain.-[6]- Simply put, the efficacy of the continuous disclosure reporting scheme under the Exchange Act, including the review by the staff of operating and financial information filed on Form 10-K and other reports, may render unnecessary the separate pre-review by the staff of registration statements and other transactional filings by reporting companies. Some argue that the possibility of Commission review of seasoned issuer transactional filings provides significant deterrent value that serves to increase the quality of public disclosures. They argue these issuers voluntarily provide negative material disclosure without the benefit of an actual review, at least partially due to the possibility that they might be reviewed. Others argue that the primary motivator in ensuring proper disclosure is the fact that the issuer is subject to liability for market fraud and other civil liability and government enforcement actions for improper disclosures. In this respect, strict liability under Section 11 for material ---------FOOTNOTES---------- -[6]- In fact, the Division of Corporation Finance appears to acknowledge this in that it does not review takedown prospectuses in the context of shelf registrations and reviews only approximately 14 to 16 percent of Form S-3 (shelf and non-shelf) registration statements. ==========================================START OF PAGE 15====== misstatements undoubtedly serves to ensure appropriate compliance with the dictate of full and fair disclosure. In the Committee's view, it is inherently difficult to measure or quantify the incidence of or avoided costs related to false or misleading statements that are never made, either because of the possibility of staff review or the threat of liability. The staff of the Committee analyzed stock-price evidence in an effort to quantify the benefit to investors provided by the review process with respect to transactional filings by reporting companies. If the information generated by the staff review is predominantly negative, and if stock prices generally reflect publicly available information, then one could expect Commission reviews, at least in certain instances, to be associated with declines in stock prices relative to the market, on average, over the course of the review. Table 3 below provides evidence regarding the impact of Commission reviews on filings for underwritten public offerings of additional common stock by Nasdaq, NYSE and Amex-listed issuers during 1993 and 1994. The evidence in Table 3 shows no statistically significant difference in the average change in stock prices relative to the market according to whether or not filings are reviewed. Even if this data is construed as demonstrating that no new material information is generated by staff review of these transactional filings, that result should not be surprising. If the continuous disclosure requirements (including the threat of liability) and staff review of periodic reports are working as ==========================================START OF PAGE 16====== intended, then no material company-related information should be disclosed during the pre-effective review process. Moreover, the statistical test was only available for repeat offers by more seasoned issuers, and was only conducted for exchange-listed and Nasdaq issuers. Therefore, no evidence was considered on the value added by staff review in initial public offerings or in the case of the smallest companies, where the value added by staff review would be expected to be greater. __________________________________________________________________________________________ Table 3 Typical Change in Stock Price from Filing to Effective Date, for Underwritten Public Offers of Additional Common Stock by 990 NYSE/Amex/Nasdaq Issuers, 1993-94, by Pre-Offer Market Capitalization, and by Whether the Filing is Reviewed by the SEC Percentage Change in Issuer Stock Price Less Corresponding Percentage Change in the Market Overall Medians Means Market No Review No Review Difference Capitalization Review Review (t- statistic) Under $100 Million -7.0% -8.9% -6.9% -7.4% -0.5% (0.21) $100 Million or -1.8% -1.2% -1.3% 0.5% +1.8% More (1.16) Difference -5.6% -7.9% (t-statistic) (5.17) (2.28) Source: Securities Data Corp. and Center for Research on Securities Prices. Includes firm commitment underwriting only. Net-of-Market stock price changes are calculated by subtracting the change in the CRSP value-weighted portfolio of all exchange- listed stocks for exchange-listed issuers, or the change in the value-weighted portfolio of all Nasdaq stocks for issuers traded on Nasdaq. Percentages changes are calculated over the period from one day before the filing date through the date the filing is declared effective. A t-statistic in excess of 1.96 indicates a difference in means that is statistically significant by conventional (i.e., 5%) standards. ==========================================START OF PAGE 17====== On balance, and consistent with the thrust of the Commission's initiatives, the Committee believes that the cost and uncertainties created by the current Commission staff review process of transactional filings might be eliminated for most issuances by large seasoned companies without any adverse loss of deterrent effect, as long as those transactional disclosures, as well as the company's periodic and other filed reports, remain subject to staff review on a routine basis after the transaction, as well as remaining subject to Securities Act liability. The possibility that a company's periodic and other filed reports as well as transactional disclosure could be reviewed after the completion of the offering should be as effective as the deterrence currently provided by the possibility of review prior to going to market. 3. Residual Costs Associated With Registering Equity Securities On Shelf Registration Statements -- Pre-offering Filing Fees, Short-Selling and Market Overhang Recognizing the costs associated with the traditional registration process and staff review, the Commission over the last fifteen years has acted to alleviate delays in going to market by adopting the shelf registration process. This process allows seasoned companies to register securities in advance for sale at a later date. Shelf registration gives a company the flexibility to enter the market quickly by offering the previously registered securities "off the shelf," either in one offering or in several tranches. When the company decides to do such a "takedown," it files with the Commission, and delivers to ==========================================START OF PAGE 18====== investors, a prospectus supplement describing the terms of the securities and the specific offering. Issuers are permitted to use the prospectus supplement to market the securities prior to their sale. Although it may be reviewed subsequent to the offering, the prospectus supplement is not subject to Commission staff review prior to its use. Shelf registration also can be used for secondary distributions by selling shareholders who wish to time their sales to coincide with favorable market price movements. As originally adopted, shelf registration required the delineation of the specific amount of each class of security to be registered. In 1992, the Commission amended the rule governing the shelf procedure to allow "unallocated" or "universal" shelf registration where companies may register an aggregate dollar amount of one or more classes of securities without having to specify the amount of each class of security that is registered.-[7]- Table 4 below reports on recent usage of shelf registration by corporate issuers of additional securities (i.e., repeat offerings). During the period from January 1992 through December 1995, on a value-weighted basis, shelf registration was used for approximately one-half of all underwritten offers of preferred stock and approximately 40 percent of all underwritten offers of ---------FOOTNOTES---------- -[7]- Simplification of Registration Procedures for Primary Offerings, Securities Act Rel. 6943 (July 16, 1992) [57 FR 32461 (July 22, 1992)] (the "Primary Offerings Procedures Release"). ==========================================START OF PAGE 19====== corporate debt, but only approximately ten percent of all underwritten offers of common stock. While sellers of additional common stock are still less likely to use a shelf registration than are sellers of preferred stock and debt, the year-by-year changes reported in Table 4 show that sellers are increasingly using the shelf registration process to sell common stock. In 1992, takedowns from shelf registrations amounted to three percent of all underwritten offers of additional common stock. In 1994 and 1995, fifteen percent of the total value of additional underwritten common stock issues came from shelf registrations.-[8]- Indeed, a recent Wall Street Journal article pointed out not only the increase in recent years in the number of shelf registration statements that include equity, but also the recent use of shelf takedowns to sell large amounts of equity in what are essentially "big block trades." -[9]- Table 4 Relative Importance of Shelf Registration as a Vehicle for Securities Sales, by Class of Security and Year Class of Cumulative Volume Shelf Takedowns, Security of Public Offers, by Year 1992-95 (% of Class Total) (billions of dollars) // Michael Santoli, Block Trades Test Traditions On Wall Street, Wall St. J., February 9, 1996, at B12B, col. 3 ("Santoli") ("Shelf filings that cover equity have steadily become more common, rising 18% to 110 in 1995 after climbing 26% in 1994"). Shelf Class 1994 1995 Takedown Total 1992 1993 Common 16.8 156.1 3 9 15 15 Stock Preferred 44.0 89.4 38 47 60 65 Stock Corporate 661.1 1648.7 48 45 39 33 Debt Source: Securities Data Corp. Excludes best efforts deals, private placements, initial public offerings, and all sales of asset-backed securities. ---------FOOTNOTES---------- -[8]- Of the $9.4 billion in common stock sold using shelf registration from January 1992 through December 1994, the Committee staff estimates that at least $7.6 billion was sold using the unallocated shelf process. -[9]- Michael Santoli, Block Trades Test Traditions On Wall Street, Wall St. J., February 9, 1996, at B12B, col. 3 ("Santoli") ("Shelf filings that cover equity have steadily become more common, rising 18% to 110 in 1995 after climbing 26% in 1994"). ==========================================START OF PAGE 20====== One significant deterrent to the use of the shelf registration process has been issuers' fear of a dilutive "market overhang." Overhang often depresses the trading price of a company's stock once a registration statement is filed disclosing the issuer's plans to issue additional common stock. Generally, this market overhang effect seems more pronounced for smaller issuers. Committee member Dr. George Hatsopoulos submitted a compilation of repeat (mostly non-shelf) offerings of common stock under $50 million completed in the five-year period ending August 9, 1994 (1401 transactions) that showed an average decline of the issuer's stock price by six percent from the time of filing to the time of the public offering.-[10]- A ---------FOOTNOTES---------- -[10]- Documents for Advisory Committee Meeting, May 8, 1995, Tab C (Letter dated May 4, 1995 from George N. Hatsopoulos to Commissioner Steven M.H. (continued...) ==========================================START OF PAGE 21====== comparable analysis is reported in Table 3 above for repeat offerings of common stock by companies with pre-offer market capitalization (rather than offer size) of more or less than $100 million. Among smaller issuers, net-of-market stock price declines averaged approximately seven percent. Among larger issuers, there was no significant decline in stock prices on average, indicating that the market overhang effect appears less pronounced among the class of issuers that initially would be eligible for the company registration pilot. Some or all of the decline in the market price of smaller issuers could be due to anticipation of the dilutive effect of the new offering. The higher average floatation costs reported for smaller issuers in Table 1 above are consistent with this possibility. The market also may view a registration statement for possible future sales of common stock as a signal that, in management's view, the price of the stock has peaked. The evidence in Table 3 above, that price declines are concentrated among the smaller issuers, is consistent with this view, since smaller companies generally are less closely followed by analysts, and the investment community is generally less well informed about managements opinions. For these reasons, disclosure of an issuer's intent to issue a significant amount of equity can be material to investors particularly with respect to smaller companies. Dr. Hatsopoulos, ---------FOOTNOTES---------- -[10]-(...continued) Wallman) ("Hatsopoulos Letter"). ==========================================START OF PAGE 22====== however, raised concerns that prior public notice of an issuer's impending sale of additional common stock provides market arbitragers with an opportunity to sell the stock short, possibly exacerbating the anticipated price decline.-[11]- As stated by Dr. Hatsopoulos, [o]nce an offering is announced, [the arbitragers] sell the company's stock short with the intent to cover their short at the offering. Because of fear for such an activity, we decided many times in the past to do offerings offshore and register the shares after completion.-[12]- It has been reported elsewhere that short sellers tend to be active in the shares of companies once the company files a registration statement for a public offering of common stock, presumably because the pendency of an added supply of common stock reduces the likelihood that the short seller will be caught in a squeeze.-[13]- Ultimately, both the company and the ---------FOOTNOTES---------- -[11]- A market participant has described the phenomenon as a foolproof way to make money. The market has created a self-fulfilling prophesy about what will happen when you file: the price goes down, the short interest goes up, buyers go to the sidelines, and the deal comes at a much, much lower price. Bernstein, Some New Buyers Emerge From Gloom, BioCentury, The Bernstein Report on BIOBusiness, May 6, 1995, at A3. -[12]- Hatsopoulos Letter, supra n.10, at 4. -[13]- It is estimated that short interest during the period between filing date and offer date is approximately three times greater than it is in the three months before the filing date, based on a sample of 474 offerings of additional common stock by exchange-listed issuers. See Assem Safieddine and William J. Wilhelm, Jr., "An Empirical Investigation of Short-Selling Activity Prior to Seasoned Equity Offerings," December (continued...) ==========================================START OF PAGE 23====== existing shareholders suffer as a result of adverse effects on the market price of the company's stock, which could significantly raise the cost of equity capital for issuers. It was particularly because of these issuer concerns with potential market overhang that the Commission adopted the unallocated shelf procedure to facilitate the use of shelf registration for delayed offerings of common stock and convertible securities.-[14]- The recent upward trend in the percentage of all underwritten offerings of common stock that are made using the shelf registration process suggests that the 1992 introduction of the unallocated shelf procedure has met with some success. However, the continuing need to specify an aggregate dollar amount of securities to be offered apparently has perpetuated market overhang concerns. Industry participants advised the Committee staff that they still recommend against use of even the unallocated shelf for common stock offerings, except where the issuer is large enough to be less susceptible to market ---------FOOTNOTES---------- -[13]-(...continued) 1995, Unpublished Paper, Boston College. SEC rules prohibit short sales of equity securities in advance of public offerings, but only when the short sales are covered with securities sold in the offering. See Exchange Act Rule 10b-21 [17 CFR 240.10b-21]. -[14]- See Primary Offerings Procedures Release, supra n.7. ==========================================START OF PAGE 24====== overhang or where the issuer already has disclosed their intention to raise significant equity capital.-[15]- Although some market participants indicated potential interest in advance notice to the market of significant equity offerings, the Committee concluded that simultaneous notice to the market through the filing of a Form 8-K, as well as disclosure of the issuer's financing activities in other reports, should adequately serve to protect the interest of investors without requiring issuers -- at least seasoned issuers -- to signal their intentions months in advance. Indeed, in many instances under the company registration system, public notice of a specific offering would occur earlier than required today under shelf offerings, where transactions are disclosed in prospectus supplements first filed with the Commission up to two business days after their use. In the Committee's view, the long-term market overhang effect could be reduced, or even eliminated, under a company registration system that does not mandate the advance filing of a registration statement covering a specified dollar amount of securities, while appropriate notice to the market of an offering can be expedited through the company registration Form 8-K filing requirement. ---------FOOTNOTES---------- -[15]- Transcript of May 8, 1995 Advisory Committee Meeting at 146 (describing staff discussions with representatives of financial executives and underwriters); Documents for Advisory Committee Meeting, July 26, 1995, Tab E (Letter dated July 21, 1995 from Michael Holladay, General Attorney of AT&T, to the Committee). ==========================================START OF PAGE 25====== There are other limitations to the current unallocated shelf process that would be eliminated as a result of the implementation of a company registration system. First, a shelf may not be used until the shelf registration statement is declared effective by the staff, perpetuating much of the uncertainty and delay that the shelf system was adopted to address. Based upon information available to the staff, as of December 31, 1994, approximately 58% of the initial takedowns of securities off an unallocated shelf that included common stock occurred within 60 days of the initial filing of the Form S-3 registration statement. Approximately 39% occurred within 40 days of the filing. In roughly 50% of the offerings, half the time between the filing of the registration statement and the initial takedown occurred prior to the effective date. Second, the filing fee for shelf registration is non- refundable and payable at the time of registration rather than upon the actual takedown of securities (unlike the "pay-as-you- go" structure of company registration). Third, in most cases, the issuer only may register on the shelf an aggregate dollar amount of securities that it reasonably expects to be offered and sold within the next twenty-four months. Moreover, in the case of at-the-market offerings of equity securities,-[16]- the ---------FOOTNOTES---------- -[16]- An "at-the-market" offering is an offering of securities into an existing trading market for outstanding shares of the same class at other than a fixed price on or through the facilities of a national securities exchange or to or through a market maker otherwise than on an exchange. (continued...) ==========================================START OF PAGE 26====== offering must be conducted by an underwriter and the amount of any voting stock that is registered for this purpose may not exceed ten percent of the aggregate market value of the registrant's outstanding voting stock held by non-affiliates. Company registration also would create more flexibility regarding prospectus delivery than the current shelf system. Shelf issuers are required to deliver a final prospectus no later than delivery of the confirmation, and are restricted in the use of selling materials or term sheets absent prior or simultaneous delivery of the prospectus. Finally, company registration would make the streamlined offering process available in connection with material acquisitions, whereas the current shelf registration system generally does not. ---------FOOTNOTES---------- -[16]-(...continued) Securities Act Rule 415(a)(4)(i) [17 C.F.R. 230.415(a)(4)(i)]. ==========================================START OF PAGE 27====== B. Indirect Costs Associated with the Current Regulatory Scheme 1. Securities Act Concepts Designed to Ensure the Registration of Public Offers and Sales Can Produce Unnecessary Costs and Uncertainties and Reduce Flexibility in Structuring Financing Transactions Gun-jumping. Any improper soliciting activities prior to, or during, the registration process (generally referred to as "gun-jumping" or "beating the gun")-[17]- violate the registration requirements of the Securities Act. These restrictions apply to both large, seasoned public companies that have been publicly reporting for years, as well as small, non- public companies contemplating an initial public offering. If the Commission staff determines that gun-jumping has occurred, the effective date of the registration statement may be delayed in an effort to mitigate the effects of the improper publicity on the market.-[18]- Although the Commission's policies in this area are not intended to restrict the ordinary flow of information to investors and analysts, the difficulties of drawing clear distinctions between permitted and prohibited market communications have led some reporting companies to limit their ordinary course disclosures to the marketplace while ---------FOOTNOTES---------- -[17]- See generally Stanley Keller, Basic Securities Act Concepts Revisited, INSIGHTS, May 1995, at 5 (the "Keller Article"). -[18]- Gun-jumping also can afford purchasers a right of rescission under Section 12(a)(1) of the Securities Act. ==========================================START OF PAGE 28====== contemplating or conducting a public offering.-[19]- Thus, although the gun-jumping doctrine may serve to protect purchasers in the offering by hindering circumvention of the registration requirements, it also may chill or delay the disclosure of some company-related information that is beneficial to the marketplace. The Committee questioned whether the chilling effect of the gun-jumping doctrine serves investor protection when the issuer is required to supply the markets with extensive public disclosures on an ongoing basis through its Exchange Act filings. Integration and General Solicitation Doctrines. In addition to the statutory "gun-jumping" restrictions, certain technical distinctions and concepts have evolved to prevent issuers from evading the protections of Securities Act registration by publicly distributing unregistered securities through private placements, or through affiliates acting as conduits to the public. Such distinctions and concepts have injected a significant degree of legal uncertainty into the capital ---------FOOTNOTES---------- -[19]- Although not necessarily representing the current views of the Commission or the Commission staff, this cautious approach is based upon longstanding Commission pronouncements in this area. See Guidelines for the Release of Information by Issuers Whose Securities Are in Registration, Securities Act Rel. 5180 (August 6, 1971) [36 FR 16506 (August 21, 1971)] (although companies are free to publish factual information while in registration, they must refrain from making "predictions, projections, forecasts, or opinions with respect to value"). See also Securities Rel. 5009 (Oct. 7, 1969) [34 FR 16870] and 4697 (May 28, 1964) [29 FR 7317]. ==========================================START OF PAGE 29====== formation process, thereby generating additional costs. The Committee also questioned whether such distinctions are necessary in the case of a seasoned issuer for which the same level of information is continuously provided to the markets as would be provided through the registration process. Under the federal securities laws, in certain circumstances, separate offerings that could each independently meet the conditions for an exemption from registration may be deemed to be "integrated" into a single offering for which no exemption is available. The integration test applied by the Commission-[20]- is intended to prevent issuers from circumventing the registration requirements by dividing a single plan of financing into separate offerings in order to obtain an exemption that would not be available for the entire transaction. There are a few safe harbors that offer some level of comfort by assuring non-integration of certain exempt offerings separated by at least six months from another offering.-[21]- If an ---------FOOTNOTES---------- -[20]- The SEC applies a five-factor test to determine whether separate offerings are to be integrated, or combined into a single offering. Integration may be required when: (1) the offerings are part of the same financing plan; (2) the offerings are made for the same general purpose; (3) the same class of security is issued in each of the offerings; (4) the offerings are made at or about the same time; and (5) the same kind of consideration is to be received in each of the offerings. See Non-Public Offering Exemption, Securities Act Rel. 4552 (November 6, 1962) [27 FR 11316 (November 16, 1962)]. -[21]- See Securities Act Regulation D [17 C.F.R. 230.502]; Securities Act Rule 147 [17 C.F.R. (continued...) ==========================================START OF PAGE 30====== issuer is unable to comply with a safe harbor, depending on the facts, its otherwise exempt offerings may be integrated, resulting in a Section 5 violation. A private offering also may lose its exempt status if, under the integration test, it is integrated with a registered offering and considered a single public offering.-[22]- A private placement of the same security that is the subject of a registration statement might avoid integration, however, if the same transaction were structured differently, e.g., if the registered security was sold off a shelf registration statement.-[23]- Needless to say, some of these distinctions have been condemned as "form over substance" and as "metaphysics."-[24]- ---------FOOTNOTES---------- -[21]-(...continued) 230.147]. -[22]- A completed non-public offering under 4(2) will not lose its exempt status as a result of a subsequent registered offering of the same class of securities. See Securities Act Rule 152 [17 C.F.R. 230.152]. A 4(2) offering will be deemed completed when the purchasers' investment decision is finalized, meaning consummation of the transaction is no longer subject to any conditions within the purchaser's control. See Black Box, Inc., SEC No-Action Letter [1990 Transfer Binder] Fed. Sec. L. Rep. (CCH) 77,256 (June 26, 1990). -[23]- See Documents for Advisory Committee Meeting, May 8, 1995, Tab H (Memorandum dated April 26, 1995 from William J. Williams, Jr. to the Advisory Committee). -[24]- See, e.g., Gerald S. Backman and Stephen E. Kim, A Cure for Securities Act Metaphysics: Integrated Registration, INSIGHTS, May 1995, at 18. ==========================================START OF PAGE 31====== Companies that tend to raise capital more frequently can be unduly burdened by the integration concept. Companies that want to conduct multiple exempt offerings within a compressed time frame often are unable to wait the necessary six months to rely on a safe harbor from integration. Also, issuers that use securities as consideration for multiple small acquisitions run the risk of having those offerings integrated -- even in situations where the acquisitions have been negotiated on a face- to-face basis between sophisticated parties. A separate concern arises from the prohibition on general solicitations in private offerings. The general solicitation doctrine is intended to prevent a broad-based offer of securities without the mandated protections of the Securities Act registration process. Therefore, public dissemination of information regarding an anticipated or pending private offering may be deemed to be a general solicitation, which would adversely impact an issuer's ability to rely on a valid exemption from registration under the Securities Act. However, since an unregistered distribution or placement of a large amount of a public company's securities, particularly common stock, can have a material effect on the issuer, and can result in significant dilution of existing shareholders, information about financing activities can be important to the market and the company's existing shareholders. The Commission has attempted to provide some guidance to help issuers distinguish between acceptable market disclosure and prohibited ==========================================START OF PAGE 32====== general solicitations.-[25]- Nevertheless, news about private placements is widely disseminated. In fact, third parties routinely publicize information about pending private placements, including information that would be outside the permitted scope of the safe harbor if attributed to the issuer.-[26]- Ratings are now routinely published concerning planned private offerings.-[27]- Thus, the ---------FOOTNOTES---------- -[25]- In 1994, the Commission enacted a safe harbor permitting reporting issuers to disclose publicly certain limited information regarding proposed unregistered offerings. Information that is more pertinent to the offering process, such as the underwriter's name, may not be disclosed. See Securities Act Rule 135c [17 C.F.R. 230.135c], as adopted in Simplification of Registration and Reporting Requirements for Foreign Companies; Safe Harbors for Public Announcements of Unregistered Offerings and Broker-Dealer Research Reports, Securities Act Rel. 7053 (April 19, 1994) [59 FR 21644 (April 26, 1994)]. In addition, the Commission has proposed to amend its annual and quarterly report forms to mandate disclosure of unregistered placements of common equity (and common equity equivalents) in an issuer's periodic reports. See Streamlining Disclosure Requirements Relating to Significant Business Acquisitions and Requiring Quarterly Reporting of Unregistered Equity Sales, Securities Act Rel. 7189 (June 27, 1995) [60 FR 35656 (July 10, 1995)]. -[26]- For instance, publications such as the Private Placement Letter provide detailed information on a weekly basis regarding rumored and completed private placements, often naming the investment banking firm(s) acting as placement agent or underwriter and discussing ranges of pricing information. -[27]- See Anne Schwimmer, S&P to Rate 144A Bond Deals Just Like Public Offerings; But Tricky Questions Still Remain For the Public/Private Hybrid, Investment Dealers' Digest, March 4, 1996, at 12, stating that "Standard & Poor's has begun to (continued...) ==========================================START OF PAGE 33====== boundaries of the general solicitation doctrine are breaking down since the very information prohibited under the doctrine is routinely being released to both the market and potential offerees prior to completion of the private placement. Indeed, the Commission recently solicited comments on the continued viability of the prohibition against general solicitation in private offerings.-[28]- The general solicitation concept has other consequences that burden an issuer's flexibility in structuring transactions without furnishing any counterbalancing investor protections. For instance, the Commission staff takes the position that the filing of a registration statement covering a specific securities offering (as contrasted with a shelf registration), even without offering activity, may constitute a general solicitation for that securities offering.-[29]- Consequently, with limited ---------FOOTNOTES---------- -[27]-(...continued) publicly release ratings on many Rule 144A private placements -- hammering home the market's view that most of these private placements are de facto public bonds behind the private veneer." Moody's Investors Service already rates 144A deals. -[28]- Exemption for Certain California Limited Issues, Securities Act Rel. 7185 (June 27, 1995)[60 FR 35638 (July 10, 1995)]. -[29]- See Circle Creek AquaCulture V, L.P., SEC No- Action Letter (March 26, 1993)("The staff also is unable to concur in your view that the prior registered offering would not constitute a "general solicitation" for purposes of rule 502(c) of Regulation D"); Letter from John J. Huber, Former Director of the Division of Corporation Finance, to Michael Bradfield, Former General Counsel of the Board of Governors of the Federal (continued...) ==========================================START OF PAGE 34====== exceptions, a private offering of the same or similar security undertaken while a non-shelf registration statement is pending or immediately following the registered offering could be tainted by the earlier general solicitation resulting in a Section 5 violation. This result may occur even if the issuer decides to abandon the public offering and withdraw the registration statement. The Commission staff also has viewed the solicitation of offerees based on the private offering exemption to be inconsistent with a subsequent filing to register the sale of the privately offered securities to the same investors.-[30]- Viewed as a single transaction, the offer was made before the filing of the registration statement and therefore constitutes gun-jumping. Such a scenario may arise where the issuer seeks to "test the waters" by soliciting indications of interest in a contemplated offering or the issuer files the registration statement after the purchasers are committed to purchase to avoid giving them restricted securities (rather than registering the resale of the securities acquired by the purchasers, as in so- ---------FOOTNOTES---------- -[29]-(...continued) Reserve System (March 23, 1984) ("The filing of a registration statement constitutes an offer to the public and thus a general solicitation of investors which precludes reliance on the exemption provided by Section 4(2)"). -[30]- See Summary of Capital Raising, Acquisition and Other Activity Involving the Division of Corporation Finance, THE SEC SPEAKS IN 1996, Vol. 1, at 146 (the "Current Issues Outline"); Keller Article, supra n.17, at 9. ==========================================START OF PAGE 35====== called "PIPES" transactions).-[31]- Section 5, in the view of the staff, requires that the offer and the sale both be either private or public.-[32]- Otherwise, the registration of the sale to investors solicited privately "would deprive public purchasers from those investors of the protection of registration."-[33]- It is questionable whether the validity of exemptions from registration should depend on slight gradations in the structure of transactions, especially where the transactions do not differ in their economic substance. Because in some instances there are no bright-line tests for determining when separate offerings will be integrated, some argue that issuers often incur considerable expense and delay in procuring legal opinions on this point and in structuring transactions to satisfy formulaic and formalistic interpretations. Consequently, the Committee concluded that the integration and general solicitation concepts often needlessly complicate a company's capital-raising activities. Since in the case of seasoned issuers, the registration process often does not provide any additional disclosure concerning the issuer to the markets, preservation of these concepts can only be justified by the need to ensure the sanctity of the transactional registration ---------FOOTNOTES---------- -[31]- "PIPES" refers to "private investment, public equity." Keller Article, supra n.17, at 7. -[32]- See Current Issues Outline, supra n.30. -[33]- Keller Article, supra n.17, at 6. ==========================================START OF PAGE 36====== requirements. The recommended pilot would address these issues - - at least for those issuers initially eligible for the pilot -- by treating all offers and sales by a registered company as registered for disclosure and liability purposes, regardless of whether made on a public or private basis. Once company registration is extended to all issuers (with whatever additional protections, if any, are needed for investors), these concerns could be addressed directly for smaller issuers as well.-[34]- Constraints on Resales - Statutory Underwriters and Affiliates. Although Section 4(1) of the Securities Act provides an exemption from registration for sales of securities by persons other than an "issuer, underwriter or dealer," under the current system registration may be required when "restricted" securities (securities issued in a private placement) are resold by investors. Furthermore, the registration requirements place restrictions on the ability of a person who controls or is controlled by or under common control with the company, i.e., an "affiliate," to resell both restricted and unrestricted securities.-[35]- This restriction also extends to persons ---------FOOTNOTES---------- -[34]- Until such time as the company registration system completely replaces the current system, other initiatives may address certain of these issues. See, e.g., the proposal for "pink herring" registration of offers, as described in the Report of the Task Force on Disclosure Simplification to the Securities and Exchange Commission (March 5, 1996) ("Task Force Report"), at p.31. -[35]- To ensure that routine trading transactions between individual investors do not trigger the (continued...) ==========================================START OF PAGE 37====== or entities that are affiliates of a company that was acquired by the issuer in exchange for the issuer's securities.-[36]- Consequently, this restriction may hinder a public company in using its securities for business acquisitions. These constraints arise from the broad interpretation of the statutory ---------FOOTNOTES---------- -[35]-(...continued) disclosure obligations associated with registered public offerings, Section 4(1) of the Securities Act [15 U.S.C. 77d(1)] provides an exemption from registration for transactions by a "person other than an issuer, underwriter or dealer." Purchasers from the issuer who sell their securities nevertheless may be deemed to be "statutory underwriters," and hence unable to rely on Section 4(1), if they are found to have acted as links in a chain of transmission of securities from the issuer to the public. Section 2(11) [15 U.S.C. 77b(11)] provides that persons who control, or are controlled by, or under common control with the issuer shall be considered "the issuer" for the purposes of determining who is an underwriter. Thus, distributions of outstanding securities can trigger the application of the underwriter concept to require registration if the sale is by or on behalf of an affiliate of the issuer. The statutory provision applies even where the affiliate acquired the shares in the open market or in a registered offering by the issuer. -[36]- When an issuer offers securities in exchange for other securities in certain business combinations, or in certain asset acquisitions, the offer and subsequent exchange may be deemed an offer and sale for the purposes of the Securities Act. Securities Act Rule 145 [17 C.F.R. 230.145]. Any affiliate of the acquired company who receives securities of the acquiror company and subsequently resells those securities in public transactions without registration may be deemed an underwriter of such securities unless they are sold in compliance with the quantity limitations and other restrictions of Rule 144 (except the holding period requirement). Rule 145(d) [17 CFR 230.145(d)]. ==========================================START OF PAGE 38====== definition of "underwriter" set forth in Section 2(11) of the Securities Act and are intended to protect the integrity of the registration scheme against the risk of an issuer's indirect distribution of securities to the investing public through affiliates or private placement participants. If such a distribution is deemed to occur through the conduit of a statutory underwriter, and the issuer is relying on a private placement exemption, loss of the Section 4(1) exemption by a seller may cause the issuer to lose its exemption as well. Despite Commission efforts in adopting and refining Rules 144 and 144A to provide guidance in this area and to limit the restraints on resales to only those situations where necessary to provide investor protection,-[37]- significant burdens and uncertainties remain. The Committee examined whether restrictions on resales continue to make sense in today's markets, particularly where the issuer files periodic reports under the Exchange Act. For these issuers, requiring separate registration of the resales generally does not provide any information that has not already been assimilated by the market ---------FOOTNOTES---------- -[37]- The Commission has provided detailed safe harbor protections under Rule 144 for resales of restricted securities and affiliate sales that are subject to various conditions, including holding periods, limitations on selling methods, and volume restrictions. Securities Act Rule 144 [17 CFR 230.144]. Similarly, under Rule 144A, the Commission has provided a safe harbor for resales of restricted securities to certain large sophisticated institutions, known as qualified institutional buyers, or "QIBs," subject to non- fungibility limitations and other requirements. Securities Act Rule 144A [17 CFR 230.144A]. ==========================================START OF PAGE 39====== from the company's Exchange Act reports. In such instances, the costs of monitoring compliance with Rule 144 by control persons and the diminished liquidity of shares held by any officer, director or substantial shareholder deemed an affiliate, do not appear to be justified. In addition, the Committee viewed the resale restrictions imposed on the affiliate of an acquired company who receives securities in an acquisition as reducing the incentives for the use of securities as consideration in acquisitions. As a consequence, both acquirors and acquirees could incur unnecessary costs, including potentially adverse tax consequences that may result if the parties resort to an acquisition for cash instead. The burdens created by these resale restrictions do not impact solely on the issuer and its affiliates. Institutional investors subject to regulatory capital requirements and liquidity standards, as well as other fiduciaries, must monitor and limit the amount of restricted securities in their portfolio. They also must monitor their resales to ensure compliance with Rule 144 and Rule 144A requirements. The institution's monitoring can become unduly complicated if it also holds registered securities of the same issuer, particularly where the securities are of the same class. It was hard for the Committee to justify segregation of the same securities based upon the method of issuance, especially since the subsequent purchaser of either the registered security or the non-registered security would rely on the same body of publicly available information to ==========================================START OF PAGE 40====== make its investment decision, regardless of which security was purchased. Company registration should eliminate the need for these restrictions on resales. The pilot, by eliminating most of the incentives for issuing restricted securities in exempt offerings and by narrowing the applicability of these resale restrictions to a much smaller group of those who are otherwise affiliates and underwriters, will significantly curtail the potentially unnecessary application of resale restrictions, including in the context of acquisitions. In this way, the pilot company registration system will provide a means for issuers to avoid the costs and risks associated with complying with these legal concepts adopted to police the transactional registration process. 2. Mandatory Prospectus Disclosure Requirements Do Not Meet Investor Needs in the Most Efficient Manner The requirement that a prospectus be delivered to investors in connection with an offering has traditionally been viewed as one of the most important protections of the Securities Act. In practice, however, many have begun to doubt the usefulness of delivery of a mandated disclosure document, particularly where full information concerning the issuer is readily available through the issuer's Exchange Act's filings. The delivery requirement does not appear to justify the costs in terms of the usefulness of the information provided. Instead of providing information of the kind and in the amount sought by investors, ==========================================START OF PAGE 41====== issuers often provide legalistic disclosure documents that are difficult to read, hard to understand, prepared with litigation in mind, and delivered after the investment decision is made.-[38]- Although there are no explicit Commission mandated disclosure requirements in Rule 144A placements other than from an antifraud perspective, investor demand has resulted in the use of 144A offering circulars oriented towards providing useful information to the prospective purchasers prior to their investment decision. This experience with Rule 144A demonstrates that meaningful disclosure will be provided even in the absence of an express delivery requirement, and in fact, may result in better and more meaningful disclosure delivered prior to, not after, the investment decision is made. -[39]- Under the current process, after the filing of the registration statement but before it is declared effective, the underwriter may use the waiting period to solicit indications of ---------FOOTNOTES---------- -[38]- Transcript of May 8, 1995 Advisory Committee Meeting at 156 (statement of Dr. Burton Malkiel). See also Documents for Advisory Committee Meeting, September 29, 1995, Tab E (Letter dated September 27, 1995 from The Association for Investment Management and Research to Commissioner Steven M.H. Wallman); Task Force Report, supra n.34, at 17. -[39]- Ironically, the current "all or none" requirements that impose disclosure and delivery obligations in registered offerings, but not in exempt offerings, has the effect of causing issuers to seek capital in the less regulated markets where investors have fewer legal remedies. Arie L. Melnik & Steven E. Plaut, Disclosure Costs, Regulation, and Expansion of the Private-Placement Market, 10 Journal of Accounting, Auditing, & Finance 23 (1995). ==========================================START OF PAGE 42====== interest or otherwise market the securities. Other than the preliminary prospectus, no written materials explaining the offering may be distributed to investors before the registration statement is declared effective. Following effectiveness of the registration statement, the final prospectus containing the information mandated by Section 10 of the Securities Act must be sent or given to investors before or at the time written selling materials are sent or given, as well as before or at the time the purchaser is sent or given the written confirmation of sale. Because these restrictions apply only to written statements, not oral selling efforts, the current system may actually encourage oral solicitations over written solicitations.-[40]- The prospectus delivery requirements thus make it difficult to deliver term sheets or computational material or otherwise provide useful information in writing to investors prior to the availability or finalization of all mandated information.-[41]- Moreover, in those instances where no preliminary prospectus or selling materials are distributed, the only prospectus that would ever be received by investors would be the final prospectus, which is not required to be delivered until the confirmation of sale. In fact, if the registered securities are listed on an exchange, the prospectus delivery requirement ---------FOOTNOTES---------- -[40]- Linda C. Quinn, Reforming the Securities Act of 1933-A Conceptual Framework, INSIGHTS, January 1996, at 25. -[41]- See Kidder Peabody Acceptance Corp. I, SEC No- action Letter (available May 17, 1994). ==========================================START OF PAGE 43====== may be satisfied merely by the issuer or underwriter delivering copies of the prospectus to the relevant exchange for the purpose of redelivery to members of the exchange upon their request.-[42]- Company registration will eliminate the often formalistic and unnecessary burden of physically delivering a formal prospectus and will provide issuers with the ability to decide what information to deliver to investors in connection with the marketing of a securities offering. This additional flexibility promises to provide investors with more relevant information in a more timely manner than if across-the-board prospectus delivery requirements continued to be imposed.-[43]- The proposed company registration system is crafted to achieve this goal by requiring information to be provided to the market earlier than under the current system, by permitting the provision of the ---------FOOTNOTES---------- -[42]- Securities Act Rule 153 [17 C.F.R. 230.153]. In addition, Securities Act Rule 174 [17 C.F.R. 230.174] exempts transactions in securities of a reporting company from the requirement under Section 4(3) of the Securities Act [15 U.S.C. 77d] that dealers deliver a prospectus to subsequent secondary market purchasers of the registered securities for a period of time after the registration statement has been declared effective. -[43]- In the words of one Advisory Committee member, "I am thoroughly convinced that a one-page prospectus would actually give investors more information and more protection and not less." Transcript of May 8, 1995 Advisory Committee Meeting at 157-158 (statement of Dr. Burton Malkiel). ==========================================START OF PAGE 44====== information to be more flexibly structured, and by requiring the information to be subject to statutory liabilities. ==========================================START OF PAGE 45====== III. Changes in the Markets and Offering Processes, and the Effect on Investor Protection The increasing blurring of the lines between public, private and offshore markets, the general shift of investment volume from the primary markets to the secondary trading markets, and the historical reform of the public offering process to facilitate capital formation have resulted in new offering and investment practices. These changes have raised concerns regarding the effectiveness of the regulatory process and traditional "gatekeeping" functions. Investor protection may be adversely impacted where the burdens of the registration process cause issuers to raise capital in the private and offshore markets absent the protections of registration. A. Attractiveness of Public, Private and Offshore Markets. Despite significant Commission efforts over the years to streamline the registration process, the domestic private placement market, as well as offshore markets, remain an important source of capital for U.S. companies. In the Committee's view, the ready availability of the private and offshore markets as alternatives to the registered public markets as sources of capital, as well as the interrelationship of these markets, must shape the regulatory policy for public offerings if the regulatory scheme is to meet its investor protection purposes. Although difficult to quantify because public disclosure of such information is limited, it is thought that legal and accounting fees are not likely to be as high in transactions effected in non-public and offshore markets as compared to non- ==========================================START OF PAGE 46====== shelf offerings made in the public market.-[44]- Non- registration, however, also may involve significant costs. Historically, securities have been offered in the private placement market at significant discounts to prevailing market prices, representing a significant cost of raising capital for issuers.-[45]- One reason for this discount is that investors in private placements (and certain other exempt offerings and offshore offerings) often must accept a "holding" period of illiquidity as "the price of the issuer's outflanking the Commission's registration procedures."-[46]- In return, investors demand and receive a discount from the prevailing price of the equivalent securities trading in the public markets. In fact, the Committee staff estimates that the typical discount from market value seen in private placements of common stock by NYSE, AMEX, and Nasdaq issuers is approximately 20 percent.-[47]- ---------FOOTNOTES---------- -[44]- Documents for Advisory Committee Meeting, May 8, 1995, Tab D (Memorandum for Members of the Advisory Committee on the Capital Formation and Regulatory Processes dated April 25, 1995 from Edward Greene and Larry Sonsini to Commissioner Steven M.H. Wallman). -[45]- See Documents for Advisory Committee Meeting, March 6, 1995, Tab F (Memorandum dated March 1, 1995 from Professor John Coffee to the Advisory Committee). -[46]- Id., at 2. -[47]- Based on the median discount observed in 67 private placements reported by Securities Data Corp. in the period January 1992 - December 1994, where a selling price was disclosed. In many (continued...) ==========================================START OF PAGE 47====== The offshore markets also are being accessed in lieu of the domestic public markets. In the 1980s, the increasing globalization of the world's securities markets, coupled with the growth and speed of the transactions in the Euromarkets, along with U.S. companies' increasing interest in diversifying their shareholder base and the ease of entry into foreign capital markets, led to a significant increase in offshore offerings of securities by U.S. issuers. In order to clarify the reach across national boundaries of the registration requirements of Section 5 for companies raising capital abroad, the Commission adopted Regulation S in 1990. In doing so, the Commission made clear that offers and sales of securities occurring outside the United States are not subject to the registration requirements of Section 5.-[48]- Industry participants have advised the Committee staff that U.S. companies resort to the offshore markets for a number of ---------FOOTNOTES---------- -[47]-(...continued) cases, however, a selling price was not disclosed. This discount is many times larger than corresponding discounts observed in public offerings and reported in Table 1 above, where the typical discount is 7.1% for IPOs and 1.2% for repeat offers. -[48]- Regulation S provides safe harbors for primary offerings and resale transactions abroad that comply with certain conditions, including prohibitions on resales back into the United States for certain periods of time. See Regulation S under the Securities Act [17 C.F.R.  230.901 to 230.904]. See also Problematic Practices Under Regulation S, Securities Act Rel. 7190 (June 27, 1995) [60 FR 35663 (July 10, 1995)] (the "Regulation S Release"). ==========================================START OF PAGE 48====== reasons, including the desire to avoid the Commission and state blue sky registration requirements, or even to minimize the potential risk of loss of exemptions available for private placements. Some companies also use offshore offerings in connection with acquisitions because of the costs and other burdens of complying with Commission and U.S. GAAP requirements governing presentation of the acquired company's reconciled pro forma financial statements.-[49]- B. Blurring of Distinctions Between Public, Private and Offshore Markets. The inability to partition markets based on their regulated or unregulated status suggests that application of regulatory protections should be focused on the issuer rather than any particular transaction. By eliminating distinctions based upon the circumstances under which a security was originally issued, and instead improving the disclosure publicly disseminated by the issuer on an ongoing basis, investors in all the markets for the issuer's securities would benefit. As stated by Stanley Keller at the May 8, 1995 Committee Meeting, for all practical and economic purposes, the public and private markets are merging.-[50]- Any distinctions ---------FOOTNOTES---------- -[49]- See Streamlining Disclosure Requirements Relating to Significant Business Acquisitions and Requiring Quarterly Reporting of Unregistered Equity Sales, Securities Act Rel. 7189 (June 27, 1995) [60 FR 35656 (July 10, 1995)]. -[50]- See Transcript of May 8, 1995 Advisory Committee Meeting at 208 (statement of Stanley Keller). ==========================================START OF PAGE 49====== between the two markets have become blurred. The traditional delineations between registered securities and restricted securities have become confused through the use of strategies to minimize the impact of the resale restrictions on privately placed securities. For instance, holders of securities subject to resale restrictions, including affiliates, holders of restricted securities issued in private placements, and offshore purchasers in Regulation S offerings, are resorting to various hedging techniques (including short sales and equity swaps) to avoid or reduce the economic impact of such restrictions.-[51]- In addition, under certain conditions, issuers may resort to the use of "A/B exchange offers" to give purchasers of non- registered securities the benefits of a freely tradeable security without having to delay the offering by undergoing the registration process at the original offering stage.-[52]- ---------FOOTNOTES---------- -[51]- See Managing the Managers, The Economist, February 10, 1996, at 19. -[52]- Under the current system, privately placed securities may be registered for resale if the issuer is willing to agree to pay that expense. Resale registration often occurs promptly after the closing of the private placement. In the resale registration statement, resellers must be named as selling shareholders. Therefore, they could be subjected to statutory underwriters' liability under circumstances where it may not be feasible or economical for them to make a reasonable investigation of the issuer's public disclosures. There also is a prospectus delivery obligation. Pursuant to a line of no-action letters, the so-called "A/B exchange offer" allows certain restricted securities to be converted into (continued...) ==========================================START OF PAGE 50====== In the case of issuers who are already reporting issuers prior to the issuance of the restricted securities, the structure of this process seems to be an unnecessary formalism devised to ensure technical compliance with the transactional mandates of the Securities Act.-[53]- Further, while difficult to defend on a legal or economic basis, the Commission's line-drawing prohibiting the use of the A/B exchange offer for common equity of domestic issuers, like the non-fungibility requirement of Rule 144A, appears necessary solely to prevent the wholesale undermining of the current registration scheme, not to protect purchasers of the securities in the trading markets. ---------FOOTNOTES---------- -[52]-(...continued) freely tradeable securities through the mechanism of a registered exchange offer of an identical security without all of the holders being classified as underwriters. See Exxon Capital Holding Corporation, SEC No-Action Letter (available May 13, 1988). See also Shearman & Sterling, SEC No-Action Letter (available July 2, 1993). The A/B exchange offer procedure is available only for nonconvertible debt securities, certain types of preferred stock, and initial public offerings or initial listings in the U.S. of common stock of foreign issuers. See Keller Article, supra n.17, at 6. This procedure is not available for common stock of domestic issuers, or of foreign issuers who already are reporting companies, nor is it applicable to market professionals who continue to be considered statutory underwriters. -[53]- At the May 8, 1995 Advisory Committee meeting, Mr. Keller described this process as really like taking a rubber stamp and just stamping on [the security] registered. Transcript of May 8, 1995 Advisory Committee Meeting at 208 (statement of Stanley Keller). ==========================================START OF PAGE 51====== Distribution practices and pricing also reflect a convergence in public and private markets. What used to be thought of as public offerings are being done privately under Rule 144A. Bearing close resemblance to public offerings, Rule 144A placements often are facilitated by investment banking firms and accompanied by detailed offering circulars making extensive disclosures regarding the offering as well as the company and its financial condition. In the traditional private placement arena, the movement is towards more standardized documentation, which minimizes the opportunities for investors to negotiate terms or to conduct individual due diligence.-[54]- Some investment banks even have combined or closely aligned different practice groups (both public and private) in order to compete for business in a competitive marketplace.-[55]- ---------FOOTNOTES---------- -[54]- See ACIC Designs Pamphlet to Make Private Market User Friendly, Corporate Financing Week, February 20, 1995, at 6. See also Private Placement Process Enhancements, American College of Investment Counsel, Transaction Process Enhancement Committee (January 1995). -[55]- See Kimberly Weisul, Integrating Private and Public Product at Merrill; 'The Lines Continuously Blur' Between Two Teams Sitting 30 Feet Apart on Merrill's Trading Floor, Investment Dealers' Digest, August 28, 1995, at 19. In addition, the same article states that Goldman, Sachs & Co. also is well-noted for the close collaboration between its private and public teams. See also Ronan Donohue, The Private Market's Creative Drive; The Private Placement Market Has Become So Creative That the Exotic is Commonplace, Investment Dealers' Digest, March 4, 1996, at 14 ("Donahue"), stating that "most investment banks have moved to house 144A activity under the capital markets umbrella with all the fervor of syndicate selling (continued...) ==========================================START OF PAGE 52====== Likewise, on the buy side, the line between debt issued under Rule 144A and the public bond market also has become thin.-[56]- Due to the active participation of mutual funds as both buyers and sellers of Rule 144A debt securities, liquidity is readily available, even without subsequent registration.-[57]- In fact, participants in the market have come to view the designation of a security as a "Rule 144A security" as more of a technicality rather than as a distinction of any economic consequence.-[58]- Further evidence of the blurring of the private and public markets is provided by recent news articles discussing the shrinking of the traditional pricing premium on debt offerings in both the traditional private placement market and the Rule 144A ---------FOOTNOTES---------- -[55]-(...continued) and screen-based trading. At Salomon, underwritten 144As are executed like public deals . . . . Merrill Lynch has practically amalgamated the two activities, as has Goldman Sachs." -[56]- See, Donahue, supra n. 55, at 24, stating that "further evidence emerged during the year that the fine line between the 144A and the public bond market is becoming almost gossamer." -[57]- Mutual Funds Are Key to 144A Bond Liquidity, Private Placement Letter, September 18, 1995, at 12. -[58]- As stated by a trader, "I bought a couple of 144As yesterday and, quite frankly, forgot they were 144As. . . . The forms came across my desk to remind me. . . . Other than to comply with technical restrictions, we don't even really think of 144A as a category." Id. ==========================================START OF PAGE 53====== market.-[59]- With regard to the private placement market, "ferocious competition has driven down both spreads for investors and fees for intermediaries."-[60]- Likewise, as the Rule 144A market for the securities of domestic issuers has grown, the market has become more efficient and liquid, thereby reducing the illiquidity premium. The liquidity provided by both registration rights and the A/B exchange offer technique also could be contributing to the narrowing of spreads in the Rule 144A market. However, the regulatory burdens for equity are still significant (with U.S. issuers of common equity generally not being able to avail themselves of the beneficial treatment under Rule 144A or A/B exchange offers), thereby still imposing significant costs on issuers. ---------FOOTNOTES---------- -[59]- See Anne Schwimmer, Should Retail Investors Buy Private Placements?; "After Three Years, You Can Sell It to Grandma," Investment Dealers' Digest, August 28, 1995, at 11. See also Anne Schwimmer, 144A Bond Market Surges with Volume and Liquidity; Reaches Critical Mass after Years of False Starts, Investment Dealers' Digest, August 21, 1995, at 12; Rosalyn Retkwa, Private Placements Push for Strategic Part in Corporate Finance Picture, Corporate Cashflow Magazine, December 1995, at 26. -[60]- Welcome to the Free-for-All; Private Placement Bankers Adjust to a Radically Changing Marketplace, Investment Dealers' Digest, August 28, 1995, at 14. See also Private Placements Becoming Cheap Alternative to Public Markets, Corporate Financing Week, April 17, 1995, in which market participants state that "[p]rivate placement yield spreads have tightened and fees have shrunk to the point where it is often cheaper for issuers with less than $100 million of debt to tap the private versus the public market." ==========================================START OF PAGE 54====== In addition, the increasing use of the offshore markets by U.S. issuers has raised regulatory concerns regarding the effectiveness of rules separating the offshore and domestic markets, particularly where the only trading market for the security is in the United States.-[61]- Due to the resale restrictions on Regulation S securities, upon issuance, they are not supposed to trade freely with any comparable securities in the United States. Consequently, the Regulation S securities, particularly equity, usually are priced at a discount to the U.S. market price. Non-U.S. investors may attempt to capture this spread, however, by creating short positions in the United States with the intent to cover the position with the lower priced ---------FOOTNOTES---------- -[61]- The legal risk of flowback of securities issued offshore into the domestic public markets increases substantially with equity offerings by U.S. issuers of listed securities, particularly where there is no market for the securities outside the United States. See Edward F. Greene and Jennifer M. Schneck, Recent Problems Arising Under Regulation S, INSIGHTS, August 1994, at 2 (the Greene/Schneck Article ). Any such flowback without a valid exemption would expose the issuer to Commission and private litigation based on the failure to register the securities. While it is possible to register for resale securities initially offered outside the United States through the use of a "flowback" registration statement, unless the entire offshore distribution is registered for flowback, there would be practical difficulties in determining which of the securities were registered under the Securities Act given the fungibility of securities in the secondary markets. See Ronald R. Adee, Flow-back Registration Statements, INSIGHTS, April 1988, at 10. ==========================================START OF PAGE 55====== Regulation S securities.-[62]- In the alternative, a non- U.S. investor with a valid exemption from registration can sell the Regulation S securities back into the United States upon expiration of the Regulation S holding period, which can span as little as 40 days. Thus, the securities placed outside the United States in reliance on Regulation S may be traded back into the United States, in some cases almost immediately, with no investor protection under the Securities Act for any subsequent purchasers in the United States. Recent press reports reveal another motive for offshore offerings.-[63]- Despite technical compliance with Regulation S's resale restrictions, some issuers reportedly have used the rule to effect an indirect illegal distribution to U.S. investors by, among other things, placing unregistered securities temporarily offshore to evade registration requirements.-[64]- Similarly, holders of restricted ---------FOOTNOTES---------- -[62]- Greene/Schneck Article, supra n.61, at 6. -[63]- See, e.g., Jaye Scholl, Easy Money: How Foreign Investors Profit at the Expense of Americans, An Invitation to Scamsters?, Barron's, April 29, 1996, at 31; Laurie Cohen, Rule Permitting Offshore Stock Sales Yields Deals That Spark SEC Concerns, Wall Street Journal, April 26, 1994, at C1; Linda C. Quinn, SEC Division of Corporation Finance Expresses Concern, INSIGHTS, April 1994, at 36. -[64]- As stated by the Commission in the recent release regarding problematic practices under Regulation S, it has come to the Commission's attention that some market participants are conducting placements of (continued...) ==========================================START OF PAGE 56====== securities have attempted to used the resale safe harbor of Regulation S to "wash" or remove the resale restrictions on those securities. The premise that the federal securities laws can be administered on a geographical basis is being further undermined by the ability of issuers to place offers on the Internet, which "shows no respect for those boundaries."-[65]- These developments have raised concerns regarding the effectiveness of the restrictions under Regulation S in policing the integrity of the Securities Act registration process. The effects of the merging of the public, private and offshore markets on the operation of the current Securities Act concepts and protections are grounds for significant concern. It seems clear that these concepts are no longer capable of achieving their purpose of protecting investors, and are imposing substantial costs on issuers. In the case of seasoned issuers, the benefits of attempting to preserve these distinctions are -[64]-(...continued) securities purportedly offshore under Regulation S under circumstances that indicate that such securities are in essence being placed offshore temporarily to evade registration requirements with the result that the incidence of ownership of the securities never leaves the U.S. market, or that a substantial portion of the economic risk relating thereto is left in or is returned to the U.S. market during the restricted period, or that the transaction is such that there was no reasonable expectation that the securities could be viewed as actually coming to rest abroad. Regulation S Release, supra n.48, [60 FR at 35664]. -[65]- Michael Salz, Small Stock Issuers Find a New Market on the Internet, Wall Street Journal, May 14, 1996 at 132 (quoting K. Robert Bertram, Pennsylvania Securities Commission). ==========================================START OF PAGE 57====== unclear, given the significant costs and reduced investor protection that comes from them. Rather, with regard to seasoned issuers, the Committee concluded that investor protection would be better served by a regulatory model that no longer attempts to preserve any artificial distinctions among these markets. Instead, the new regulatory model would provide for Securities Act protections for all sales to purchasers in the United States (regardless of whether the securities were first offered abroad), and would extend the type of discipline and quality of disclosure traditionally enjoyed by the primary markets to the company's continuous reporting, for the benefit of all the markets for the seasoned issuer's securities. C. Growth of Secondary Markets and Changes in Offering Techniques. Due to the explosive growth of trading in the secondary markets as compared to the primary issuance market, today most investors look to the Exchange Act for protection, rather than the Securities Act. As shown in Figure 2 in the Addendum to this Appendix A, with regard to common stock, the U.S. capital markets have shifted -- on a relative basis -- from a primary role as a source of capital to a venue predominantly for secondary trading. As shown in Figure 2, the secondary trading markets for common equity have grown exponentially in comparison to the primary issuance market, with over $5,500 billion in secondary trading versus $155 billion in primary issuances in 1995. The registered primary issuance market for ==========================================START OF PAGE 58====== common stock has remained relatively stagnant as a source of capital since 1933.-[66]- From a liability perspective, this shift is significant since the key liability provisions of the Securities Act offer protections only to purchasers of securities in the primary offering, not those purchasing an identical security in the secondary markets.-[67]- Moreover, since some believe Exchange Act reports "tend to be taken less seriously, and to be of lower quality," than documents prepared specifically for use in registered offerings,-[68]- the ultimate effect on ---------FOOTNOTES---------- -[66]- Figures 1 and 2 to the Addendum to this Appendix A. In addition, as shown in Figure 1, there has been a substitution in the primary markets of corporate debt for equity since 1983. -[67]- Although a secondary market purchaser who purchases securities that were originally registered under the Securities Act technically would be able to bring a claim under Section 11 of the Securities Act for material misstatements or omissions in the registration statement, the statute of limitations has begun to run with the initial sale by the issuer and such purchaser must be able to trace the securities purchased in the secondary market back to the original registration statement in order to maintain the Section 11 claim. Also, claims under Section 12(a)(2) of the Securities Act for material misstatements or omissions in the prospectus may only be brought against those in privity with the purchaser or who otherwise engage in soliciting activities. Pinter v. Dahl, 486 U.S. 622 (1988). -[68]- See Milton H. Cohen, The Integrated Disclosure System -- Unfinished Business, 40 Bus. Law. 987, 992 (1985) ("Cohen, Unfinished Business") (describing general agreement that the Exchange Act reports are not of the same quality as the Securities Act documents). Industry participants have informed the Committee staff that this (continued...) ==========================================START OF PAGE 59====== investor protection is potentially far-reaching for both the primary and secondary markets that price and function on the basis of those reports. Even when investors do participate in public offerings of securities, thereby receiving the protection of the Securities Act, the prospectus delivery and disclosure requirements have much less significance in the case of seasoned issuers because the company-related mandatory disclosure is incorporated by reference from the issuer's Exchange Act reports rather than physically delivered directly to purchasers. When Congress adopted the Securities Act in 1933, it envisioned that prospective investors would receive a single disclosure document containing all material information necessary to make an informed investment decision prior to making such decision.-[69]- Integrated disclosure and shelf registration have led to an ---------FOOTNOTES---------- -[68]-(...continued) conclusion is still valid today. See Transcript of July 26, 1995 Advisory Committee Meeting at 178 (statement of Roland Machold: "I used to write prospectuses myself and I can remember the first thing you did was throw away the 10-K and start from scratch. And I think that still goes on. The 10-K is filled out by clerks and the offering circular is filled out by people who have concerns"). See also Documents for Advisory Committee Meeting, September 29, 1995, Tab E (Letter dated August 1, 1995 from Robert S. Merritt, Chief Financial Officer, and Joseph J. Kadow, Vice President and General Counsel, Outback Steakhouse, Inc. to Brian T. Borders, President, Association of Publicly Traded Companies)(stating that Exchange Act disclosures could be improved). -[69]- See H.R. Rep. No. 85, 73d Cong., 1st Sess., at 8 (1933). ==========================================START OF PAGE 60====== increasing percentage of the primary issuances of securities by seasoned companies being made through the streamlined Form S-3 process,-[70]- where less of the disclosure mandated by the Securities Act is actually being delivered to investors. Instead, and appropriately, greater reliance is placed on the integrity of the Exchange Act reports to ensure a fair pricing of securities by repeat issuers. Recent rule changes adopted by the Commission to facilitate prospectus delivery in light of the movement to a three business day standard settlement time frame ("T + 3"),-[71]- and interpretive guidance issued by the Commission to assist issuers in the use of electronic rather than paper delivery of documents to investors under the federal securities laws,-[72]- preview the rapid changes occurring in the procedures used in securities offerings. Already, market participants are permitted to deliver the statutory prospectus information in more than one document. Also, such documents may be delivered to investors at ---------FOOTNOTES---------- -[70]- For information regarding the history of repeat issuances of common equity by seasoned issuers on Form S-3 over the last ten years, see Figure 4 in the Addendum to this Appendix A of the Report. -[71]- See Securities Act Rule 434 [17 C.F.R. 230.434], as adopted in Prospectus Delivery; Securities Transactions Settlements, Securities Act Rel. 7168 (May 11, 1995) [60 FR 26604 (May 17, 1995)]; Rule 15c6-1 [17 C.F.R. 240.15c6-1]. -[72]- See Use of Electronic Media for Delivery Purposes, Securities Act Rel. 7233, Exchange Act Rel. 36345 (October 6, 1995) [60 FR 53458 (October 13, 1995)]. ==========================================START OF PAGE 61====== separate intervals and in varying manners, including electronic delivery. Consequently, actual delivery of a final printed integrated prospectus to investors prior to or with the confirmation may soon become a relic of the past. As a result of these market and regulatory changes, the traditional transactional registration process may no longer be directly relevant to investors purchasing the securities of seasoned issuers. Since so much of the information deemed necessary for an investment decision is being provided through the public filing of Exchange Act reports with the Commission, the Committee believed that the original goals of the Securities Act would be better served by the adoption of new disclosure practices and procedures that should have the beneficial effect of focusing the participants in the capital formation process on enhancing the quality of the disclosure in these reports. D. Changes in Gatekeeper Role. According to Milton H. Cohen, the superiority of Securities Act disclosure is related directly to the "in terrorem" effect of the statutory liability provisions of the Securities Act on the issuer's directors, underwriters, accountants, and other gatekeepers charged with responsibility for the issuer's disclosure in connection with a public offering.-[73]- Under the traditional offering process, ordinarily there would be ample time available before the filing of a registration statement, and again before ---------FOOTNOTES---------- -[73]- See Cohen, Unfinished Business, supra n.68, at 989. ==========================================START OF PAGE 62====== effectiveness of that registration statement, for these gatekeepers to exercise their investigatory responsibilities. The lead underwriter normally participates in the drafting of the registration statement and undertakes significant investigation of the company, its business and its management in connection with an offering. This due diligence obligation has developed largely in response to the underwriter's exposure to liability for false or misleading disclosures in the registration statement. Supporters of the current liability system point out that it imposes policing responsibilities on those parties best equipped to judge the accuracy and completeness of registration disclosures. This disincentive to carelessness created by the liability structure ultimately benefits investors and the markets as a whole. Many in the underwriting and legal communities believe that it has become increasingly difficult for underwriters to discharge their due diligence responsibility in the context of the streamlined offering process afforded by integrated disclosure and shelf registration. According to a recent report on due diligence by the American Bar Association's Task Force on Due Diligence,-[74]- the informational convergence between the Securities Act and the Exchange Act as a result of integrated ---------FOOTNOTES---------- -[74]- American Bar Association Committee on Federal Regulation of Securities, Report of the Task Force on Sellers' Due Diligence and Similar Defenses Under the Federal Securities Laws, 48 Bus. Law. 1185 (May 1993). ==========================================START OF PAGE 63====== disclosure, and the severe time constraints imposed by shelf registration, make it difficult, if not impossible, for underwriters in a shelf takedown to perform a traditional, in- depth due diligence analysis of the issuer, especially since the bulk of the required company-related disclosure will be satisfied through incorporation by reference. Underwriters claim to be hampered in their due diligence efforts because they typically do not help prepare the issuer's Exchange Act reports.-[75]- Thus, with respect to seasoned issuers using the shelf process, the current system may be suffering from an erosion of the underwriter's traditional performance of due diligence, one of the key safeguards against fraud under the Securities Act liability paradigm. With the increasing use of the shelf process to conduct offerings of equity securities, the difficulties highlighted in the ABA Due Diligence Report may become further exacerbated. This trend is evidenced by recent reports of large takedowns of common equity off a universal shelf being directly placed in what are essentially block trades, as contrasted with the usual underwritten offering approach.-[76]- Underwriting firms ---------FOOTNOTES---------- -[75]- Documents for Advisory Committee Meeting, November 21, 1995, Tab E (Letter dated November 2, 1995 from the Securities Industry Association to the Advisory Committee, at 5-7)(the "SIA Letter"). -[76]- Santoli, supra n.9 ("efforts to sell stock directly are another sign of Wall Street's eroding role as gatekeeper and disseminator of information, a process that gathers force with each new application of communications technology (continued...) ==========================================START OF PAGE 64====== assert that the shift in the focus of disclosure to the periodic reports filed under the Exchange Act, as well as the streamlining of the registration process through the adoption of shelf registration, without a commensurate change in the statutory liability structure or the gatekeeper function, is fundamentally unfair and should be addressed.-[77]- Members of the board of directors likewise may have cause for concern under the current liability scheme. Substantial portions of the Securities Act disclosure requirements are now being satisfied with information incorporated by reference from Exchange Act periodic reports. Board members do not tend to pay as much attention to the preparation of information in a company's periodic reports as they would if such information was being prepared directly for a public offering document.-[78]- Nor are board members positioned to review either the Exchange Act filings or offering documents in an environment of frequent offerings conducted with minimal advance ---------FOOTNOTES---------- -[76]-(...continued) to the investment business"). -[77]- SIA Letter, supra n.75, at 7-10. -[78]- See Transcript of May 8, 1995 Advisory Committee Meeting at 166 (statement of Mr. Roland M. Machold). See also Joseph McLaughlin, Integrated Disclosure, Shelf Registration and Other Due Diligence Challenges in the Public Offering Process, PLI CONDUCTING DUE DILIGENCE 1995 (March 14, 1995), at 2. ==========================================START OF PAGE 65====== planning and little opportunity for a due diligence review.-[79]- Finally, the increased significance of the secondary markets is cause to question the wisdom of focusing the gatekeeper function on episodic transactions. Indeed, a significant portion of the reporting companies whose securities are actively traded ---------FOOTNOTES---------- -[79]- During the February 22, 1996 Advisory Committee meeting, Professor Coffee gave the following "illustrations:" I had a conversation [with an outside director] on the board of a company that has been, for the last six months, making daily sales of its equity securities to an underwriter through universal shelf registration. His problem, as he said throwing up his hands, is there is no way in the world that we can conduct daily due diligence. There is nothing in the system that tells us how we can do it or what we can do to comply with this kind of world. He went on to describe to me a case ... of a very major insurance company that has been told by its underwriters that it would be very attractive to it to be able to use the underwriter to make daily small sales in a manner that would not move the market. Again, selling equity securities through the market maybe three or four times a week in small quantities, but the board of directors and the lawyers of that large insurance company are very, very concerned that kind of process of constant sales would expose the directors to difficulties because there would be no way that they could, on a constant basis, fulfill their due diligence responsibilities. Transcript of February 22, 1996 Advisory Committee Meeting at 51-52. Professor Coffee observed that one of the intended effects of company registration -- small, frequent equity offerings not planned very many days in advance -- would present the same concerns. Id. at 52. ==========================================START OF PAGE 66====== in the public markets never access these markets for new capital.-[80]- Consequently, apart from the important discipline of the annual audit, these companies are never subjected to the type of investigation by others contemplated by the Securities Act. The company registration system, by contrast, will help alleviate some of these concerns by permitting and encouraging more and better due diligence by those in the position to be most knowledgeable, without lowering liability standards. By providing incentives and mechanisms for increased and enhanced ongoing oversight of a company's disclosures to the market, and by requiring all material development disclosure, including transactional disclosure, to be filed as part of the registration statement at the time of the offering, investor confidence in both the primary and secondary trading markets should be heightened, thereby ultimately lowering a company's cost of capital. * * * The increasing inapplicability of traditional transactional registration concepts in today's undifferentiated markets, the growth of the secondary markets, the regulatory shift to reliance on Exchange Act reports, as well as the persistent concerns with the quality of that disclosure and adequacy of gatekeeper due ---------FOOTNOTES---------- -[80]- See Figure 4 in the Addendum to this Appendix A of the Report (only 4-6% of NYSE, AMEX and Nasdaq companies made underwritten offerings of additional common stock each year since 1985). ==========================================START OF PAGE 67====== diligence in the context of today's expedited offering process, all point to the conclusion that the existing Securities Act protections and processes needed to be re-examined. Investor protection and capital formation would be better served by a regulatory system that operates to improve the quality and reliability of a company's continuous disclosure while eliminating costly transactional registration requirements and restrictions that no longer serve to protect investors. Improved disclosure can be accomplished in a number of ways, including by having senior management and the board of directors focus on and improve the procedures under which the company's reports are prepared, and through the adoption of measures to ensure more timely disclosure of significant developments, as well as through greater auditor involvement. Measures to reorder and rationalize the gatekeeper and monitor function to focus on the integrity of the company's reports on an ongoing, rather than an episodic basis, will preserve and reinforce the protections afforded by outside oversight of a company's disclosures. ==========================================START OF PAGE 1====== APPENDIX B ESSENTIAL ELEMENTS OF THE COMPANY REGISTRATION SYSTEM I. Disclosure A. Disclosure and Prospectus Delivery Under the Company Registration System 1. Company Registration Statement 2. File and Go 3. Prospectus Delivery B. Role of the Commission and Other Gatekeepers or Monitors 1. The Commission Review Process 2. The Underwriter 3. The Auditor II. Company Eligibility III. Transactions Covered A. Affiliate and Underwriter Resales 1. Sales of Restricted Securities 2. Sales by Affiliates B. Exclusions C. Offshore Offerings D. Preservation of Transactional Exemptions E. Limited Placements IV. Disclosure Enhancements Under the Recommended Company Registration Model A. Mandatory Disclosure Enhancements 1. Enhanced Involvement by Senior Management ==========================================START OF PAGE 2====== a. Top Management Certifications b. Management Report to the Audit Committee 2. Improvements in the Content and Timeliness of 1934 Act Reporting a. More Timely and Informative Reports on Form 8-K b. Form 10-K Risk Disclosure B. Conclusion V. Liability and Due Diligence Under Company Registration A. Liability Under Company Registration 1. Other Liability Approaches Considered 2. Preservation and Expansion of Statutory Liability B. Due Diligence Under Company Registration 1. Underwriters 2. Outside Directors C. Conclusion Addendum to Appendix B -- Comparison of Company Registration and Shelf Offering Systems ==========================================START OF PAGE 1====== APPENDIX B ESSENTIAL ELEMENTS OF THE COMPANY REGISTRATION SYSTEM I. Disclosure Company registration would further the traditional goals of the disclosure requirements under the federal securities laws -- to provide investors with the information necessary to make an informed investment decision and to deter fraud and overreaching. While company registration would maintain and in some cases expand the level of information about companies and their offerings that currently is made available to the markets through Commission filings, such information would be required to be made public earlier than under the current system, thereby benefitting investors in both the primary issuance market and the secondary trading markets. At the same time, company registration would afford companies offering their securities to the public the flexibility to tailor the disclosure documents delivered to investors to the nature of the transaction and the demands of the offering participants. Company registration also would maintain and reinforce the roles of outside gatekeepers and monitors and their due diligence functions in fostering the reliability of that information to meet the realities of today's markets. The primary goals of disclosure under the federal securities laws are to provide investors and the marketplace with information necessary to make informed investment decisions, and to deter fraud. Capital allocation decisions are best made on the basis of well-informed private decision-making by market participants. In an oft-quoted passage, Justice William Douglas, who once served as Commission Chairman, stated: The truth about the securities having been told, the matter is left to the investor. . . . The requirement that the truth of the securities be told will in and of ==========================================START OF PAGE 2====== itself prevent some fraudulent transactions which cannot stand the scrutiny of publicity.-[1]- Full and fair disclosure is the key to an efficient capital allocation process. Under the current regulatory scheme for public offerings, disclosure of information material to investment and voting decisions is effectuated in two principal ways. First, information is made public through the filing of a disclosure document with the Commission. This information then is available to investors, either directly by investors accessing the information themselves, or indirectly through intermediaries such as investment advisers, research analysts, and other investment professionals who analyze and redistribute that information to the investing public. The requirement under the Securities Act that a registration statement be on file with the Commission before the offering process commences is an example of this form of disclosure. This method of information dissemination is also the principal means by which the trading markets are provided with current information about issuers. The annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K are examples of this method of disclosure. Second, information is disseminated directly to investors by the issuer of the securities. The Securities Act requirement to deliver a prospectus to an investor no later than the time the ---------FOOTNOTES---------- -[1]- William O. Douglas, Protecting the Investor, 23 Yale L. Rev. 521, 523-24 (1934). ==========================================START OF PAGE 3====== confirmation of the sale is sent falls into this category, as do the requirements for delivery of a proxy statement and annual report to shareholders in connection with an election of directors, or an offer to purchase in connection with a tender offer. Prospectuses that are filed publicly with the Commission likewise serve to inform the trading markets. Experience has demonstrated that actual delivery of information to investors -- as opposed to delivery of such information to the markets through a Commission filing -- frequently is not necessary to convey information and deter fraud. Public disclosure of information concerning the issuer through Exchange Act filings, and its consequent ready availability, serve as an efficient means to facilitate informed assessments of the issuer's business prospects and financial condition and the security being offered. Public disclosure also serves to deter many of the more unsavory practices witnessed before the adoption of the Securities Act, such as self dealing by insiders and underwriters. Finally, the public availability of information also can serve to counteract overzealous selling efforts. Milton Cohen, in his seminal article "Truth in Securities Revisited," established a blueprint for rationalizing the two securities acts with respect to prospectus delivery: This is, indeed, an area for pragmatic and not merely logical answers, and I believe that the best approach in a coordinated law will be to introduce a greater degree of pragmatism -- primarily in distinguishing continuous registrants from others but also in ==========================================START OF PAGE 4====== distinguishing among different types of transactions. . . . First, a prospectus of a continuous registrant should not be required to contain information that is of no different significance or greater materiality to an offeree in a distribution than to any other investor or potential investor in securities of the same issuer. Second, a prospectus that is not required to be delivered in time to affect investment decisions should not be required at all, unless serving a purpose not adequately served by public filing alone . . . .-[2]- The Wheat Report, published in 1969, also reflected a recognition that the traditional prospectus delivery requirements mandated under the Securities Act may not be the most efficient means to disseminate information relevant to an investment decision. First, the unsophisticated investor may not be able to understand and make use of the information contained in the prospectus without the benefit of a market intermediary.-[3]- Second, in any event, because the use of a preliminary prospectus is not mandated, investors often do not receive prospectus information until delivery of the confirmation. In addition, requiring an issuer that was subject to the continual reporting requirements of the Exchange Act to put information regarding the company, as contrasted with the specific offering, in the prospectus was recognized as ---------FOOTNOTES---------- -[2]- Milton H. Cohen, "Truth in Securities" Revisited, 79 Harv. L. Rev. 1340, 1386 (1966). -[3]- See Disclosure to Investors, A Reappraisal of Administrative Policies Under the 1933 and 1934 Acts, Report and Recommendations to the SEC from the Disclosure Policy Study, at 53 (March 27, 1969) (the "Wheat Report"). ==========================================START OF PAGE 5====== duplicative and unnecessary, at least in those instances where the issuer was widely followed by the analyst community. Based upon the conclusions of the Wheat Report, as well as the recommendations of the Commission's Advisory Committee on Corporate Disclosure published in 1977,-[4]- the Commission moved to integration of the disclosure requirements of the Securities Act and the Exchange Act. Under the integrated disclosure scheme implemented in 1982, seasoned issuers can avoid providing prospectus disclosure duplicative of company information that already has been provided in its Exchange Act reports through incorporation by reference of that information into the prospectus. Under this approach, critical company- specific information required under the prospectus disclosure provisions of the Securities Act is made available to investors through the public filing of a company's periodic reports, but is not required to be repeated in the prospectus delivered to purchasers in the offering. Instead, the short-form prospectus physically delivered must provide information specific to the transaction, but generally can refer the investor to the filed reports for information regarding the seasoned company's business, management, financial condition and similar matters. ---------FOOTNOTES---------- -[4]- Wheat Report, supra n.3; Report of the Advisory Committee on Corporate Disclosure to the Securities and Exchange Commission, 95th Cong., 1st Sess. (Comm. Print 1977 ) (the "1977 Advisory Committee Report"). ==========================================START OF PAGE 6====== Thus, for more than a decade, with respect to the core financial and operating information regarding seasoned issuers, the Commission has deemed the prospectus disclosure objectives of the Securities Act to be satisfied by reliance on the public filing of this information and its incorporation by reference into an offering document, without any physical delivery of such information to investors. In addition, and as discussed more fully below, technological innovations are facilitating inexpensive electronic access to filed documents by the market and by investors and their intermediaries, thereby raising further questions regarding the continued need for delivery of disclosure documents directly to investors in the context of public offerings. ==========================================START OF PAGE 7====== A. Disclosure and Prospectus Delivery Under the Company Registration System Company registration would improve upon the crucial disclosure goals of the current filing and prospectus delivery requirements by requiring that mandated disclosure be made public, or delivered to investors, at an earlier point in time than under the current system. So long as all mandated information already has been publicly disclosed, company registration would create greater flexibility regarding the prospectus information to be delivered directly to investors. Such information would be provided based upon the issuer's and underwriter's assessment of the informational demands of the markets and participants in the offering.-[5]- 1. Company Registration Statement Under the company registration scheme, to become company- registered, an eligible company would file a Form C-1 registration statement disclosing its plans to sell securities from time to time in the indefinite future on a company- registered basis. The Form C-1 would be kept current by incorporating all existing and future Exchange Act reports into the Form C-1. The Form C-1 would contain a generic description of the type of securities the issuer anticipated issuing, as well as a general discussion of its financing plans. In essence, the registration statement would not be a single document, but rather a composite of the initial Form C-1, all existing and subsequently filed Exchange Act reports incorporated into that registration statement, as well as any post-effective amendments ---------FOOTNOTES---------- -[5]- A comparison of the proposed company registration system and the current short-form shelf registration system is included in an addendum to this Appendix B. ==========================================START OF PAGE 8====== thereto. Only a nominal registration fee would be required to be paid at the time of the Form C-1's filing, accompanied by an undertaking by the issuer to pay a fee upon each sale of securities under the Form C-1. This approach would create a "pay-as-you-go" system. Once a company is registered, no further registration process would be necessary to offer securities. To accomplish that result during the pilot under the current statutory scheme, the Form C-1 would serve as a registration statement for purposes of Section 5 of the Securities Act and register generically all types of securities and offerings (including affiliate resales) contemplated at the time of the company's registration. The issuer is given discretion to the extent it wishes to include all or just some of its securities on the Form C-1, depending on the degree of participation. Even under full participation in the system, a registered company may exclude non-convertible debt sold only to institutional buyers -- but not equity securities (including equity convertibles) or debt sold to retail buyers -- from the system. With respect to those companies electing to take full advantage of the system,-[6]- all subsequent sales of securities by registered companies and their affiliates would be deemed covered by the Form C-1 registration statement, and thus would be registered for purposes of the Securities Act. If the company had outstanding restricted securities at the time it ---------FOOTNOTES---------- -[6]- See infra p. 34-40. ==========================================START OF PAGE 9====== became company-registered, the company could effect a transition to the company registration system by specifically registering any or all of its outstanding restricted securities for resale on the Form C-1 (and paying a fee at that time), or merely allow the restricted securities to retain their restricted status until the expiration of the Rule 144 restricted periods.-[7]- All purchasers of securities from the issuer or its affiliates, therefore, regardless of the nature of the transaction, would receive freely tradeable securities, as well as the benefit of all statutory remedies that now attach to information disseminated in connection with a registered offering of securities. Thus, investor protection would be preserved and extended to a broader class of transactions, while regulatory concepts that are no longer necessary under a company registration system to protect investors -- such as gun-jumping and restricted securities -- would be eliminated. 2. File and Go Under the company registration system, a registered company could go to market in most transactions without encountering regulatory delays. Sales would be permitted immediately upon, or shortly following, the public filing of mandated disclosure regarding the transaction and any recent material developments ---------FOOTNOTES---------- -[7]- In the case of privately placed debt securities, the issuer also would have to execute a qualified indenture at the time it registers its outstanding debt to satisfy the requirements of the Trust Indenture Act, absent an exemption. ==========================================START OF PAGE 10====== concerning the company not previously disclosed in filings, along with the payment of the fee. As noted previously, the Committee considered, but determined not to review specific line-item disclosure requirements applicable to public offerings in connection with its development of a company registration scheme. Accordingly, the transactional information that must be on file at the time of an offering would be essentially the same as that required today.-[8]- Transactional information would be required to be filed at the time of the offering to provide notice of the transaction, pay the fee and provide other information material to the transaction to the extent the information was not previously disclosed in the Form C-1 (including in any post- effective amendments to, or Exchange Act reports incorporated ---------FOOTNOTES---------- -[8]- Thus, for example, in financings, in addition to updating its company-related disclosure (to the extent necessary), the issuer would need to have on file with the Commission at the time of an offering the transactional information required by the following disclosure items under Regulation S- K, to the extent applicable: Item 202: Description of the Securities Item 503: Summary Information, Risk Factors and Ratio of Earnings to Fixed Charges Item 504: Use of Proceeds Item 505: Determination of Offering Price Item 506: Dilution Item 507: Selling security holders Item 508: Plan of distribution Item 509: Interests of Named Experts and Counsel Similarly, in the case of business combinations, the information called for by current Form S-4 would be filed with the Commission. ==========================================START OF PAGE 11====== into, the Form C-1). As an example, the Form C-1 could describe the plan of distribution or possible alternative plans of distribution, and the filing at the time of the transaction need only disclose which offering technique is being employed. Similarly, use of proceeds could be generically disclosed in the Form C-1 and updated as necessary at the time of the transaction. Summary financial information and pro forma data would only be required where not previously disclosed and where material to investors. In the case of offerings under the company registration system of equity securities over a de minimis threshold (e.g., three percent), the transactional information (which would be, at a minimum, the fact that the transaction is occurring) would be required to be filed with the Commission on a Form 8-K no later than at the time of the transaction. The Committee also recommends that this Form 8-K filing requirement be applied to takedowns off the shelf under the current system. The purposes of this filing, which is not required today for short-form shelf offerings, is to ensure that this information is disclosed to the market at the time of the offering, to ensure that it is incorporated into the registration statement (and thus within the coverage of Section 11 liability),-[9]- and to provide a document prepared at the time of the offering that will facilitate the due diligence inquiries of underwriters and other ---------FOOTNOTES---------- -[9]- See infra pp. 63-64. ==========================================START OF PAGE 12====== gatekeepers or monitors. The Commission may wish to consider devising some minimal integration period for measuring offerings against the de minimis threshold (e.g., two or three business days) to provide clarity as to the filing requirement.-[10]- Separately, if the issuer's filings need to be updated with material company developments (except in a "limited placement, see Section III.E below), the issuer must disclose those developments in a Form 8-K filed in advance of the transaction. That filing also could serve as the transactional Form 8-K filing if the appropriate information is included. If this material updating information is to be provided to investors solely by incorporating it by reference into the prospectus (see next section below), then it will have to be on file a sufficient amount of time for the market to have absorbed the information before a sale is made. In de minimis equity offerings and in all debt offerings covered by the Form C-1 (see supra p. 5-6), the issuer would have a choice with respect to the appropriate means to effect the filing of the requisite transactional and material developments disclosure. It could include that information in a Form 8-K, as described above; alternatively, the company could include all of the required disclosure in the prospectus supplement that is ---------FOOTNOTES---------- -[10]- This prompt filing requirement at the time of sale may require the Commission to make accommodations to accept Form 8-K filings with respect to transactions taking place outside of normal business hours. ==========================================START OF PAGE 13====== delivered to investors, and simultaneously filed with the Commission. Consequently, in these de minimis equity offerings and debt offerings, the company registration model was made consistent with current practice under shelf registration in that the prospectus supplement would not be subject to Section 11 liability, because it is not deemed part of the registration statement,-[11]- except that company registration would require the prospectus supplement to be filed with the Commission at an earlier point in time than under the current system.-[12]- As noted, the transactional filing at the time of the offering could disclose any material changes in the registrant's affairs that have occurred since the latest filing (which could be a Form 8-K filed shortly before the offering) updating the company registration statement. Where necessary to avoid misleading investors, for example, this information would include an update of the company's MD&A disclosure. Where the updating ---------FOOTNOTES---------- -[11]- See infra p. 63-64. -[12]- Under current Rule 424(b)(2) [17 C.F.R. 230.424(b)(2)], a prospectus supplement prepared in connection with a shelf offering must be filed no later than the second business day following the earlier of the determination of the offering price or its first use. Thus, under the current system, the information in the prospectus supplement may not be disclosed to the secondary trading markets for as many as two days after its dissemination to investors in the offering. Company registration would accelerate the required filing of the prospectus supplement by at least two days since the prospectus supplement would be required to be filed simultaneously with its use. ==========================================START OF PAGE 14====== information represents a fundamental change in the information previously disclosed regarding the issuer in Commission filings, consistent with current requirements for shelf offerings,-[13]- that information must be provided either by means of a post-effective amendment or an Exchange Act report filed in lieu thereof. A prospectus supplement would not suffice for this purpose. Thus, the company registration system not only would maintain the level of information currently required to be disclosed in Commission filings concerning a particular transaction, but also would reinforce the existing obligation of a company offering securities to the market to ensure that its public disclosures are current and complete in every material respect,-[14]- and would accelerate the public disclosure of such information to investors in both the primary and secondary markets. 3. Prospectus Delivery The company registration system also would address the need to disseminate a statutory prospectus to participants in an offering. A principal goal of the Committee has been to recast the prospectus from what in many cases is its current function -- a document prepared to comply with regulatory requirements and to ---------FOOTNOTES---------- -[13]- See, e.g., Item 512(a)(1)(ii) of Regulation S-K [17 C.F.R.  229.512(a)(1)(ii)]. -[14]- See Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996). ==========================================START OF PAGE 15====== provide the issuer with a defense in the event of litigation, which often is not sent to investors until after the investment decision is made -- into a tool to convey meaningful information at the time of the investment decision. The system would continue to require transactional information to be physically delivered as part of the prospectus in those circumstances where it may be argued that delivery of that information might serve to facilitate an investor's evaluation of the issuer and the security. For example, if the company is issuing a new security, the company registration system would require that the terms of the new security, along with the specific risks of investing in the security, be delivered to potential investors. However, the company registration system also would provide the flexibility for issuers to file the information with the Commission without physical delivery to investors, where delivery is not necessary for that purpose and such information already has been disclosed to the markets through a public filing with the Commission. More significantly, company registration would allow for the use of a meaningful summary prospectus, the content of which would be dictated primarily by the informational demands of investors, rather than by regulatory mandates and litigation concerns.-[15]- Since in almost all but the smallest ---------FOOTNOTES---------- -[15]- The AIMR suggested that the Committee recommend that every offering of securities be accompanied by an offering circular that would include the key terms of the offering, but "no boilerplate or (continued...) ==========================================START OF PAGE 16====== equity offerings the company would be required to file with the Commission all mandated transactional and updating disclosure prior to any sales of securities, thereby enhancing investor protection through the earlier disclosure of this information to the markets than under the current system, issuers would be granted the flexibility and the responsibility to decide what information should physically be delivered to investors. The Committee expects that the disclosure contained in the prospectus delivered to investors, whether this prospectus is a document that resembles a traditional prospectus, selling materials, or the confirmation of sale, will be that information the issuer deems most relevant and material to the potential investors. ---------FOOTNOTES---------- -[15]-(...continued) legalese." See Documents for Advisory Committee Meeting, September 29, 1995, Tab E (Letter dated September 27, 1995 from the AIMR to Commissioner Wallman, at 3). Though not mandated, the Committee anticipates that the elimination of the prospectus delivery requirement in routine transactions will promote the use of such short- form offering documents. See also John C. Coffee, Jr., Re-Engineering Corporate Disclosure: The Coming Debate Over Company Registration, 52 Wash. & Lee L. Rev. 1143, 1159 (1995) ("Coffee, Re- engineering Disclosure"), discussing the impact of shelf registration on the disclosure in prospectuses: Of course, the prospectus largely deteriorated into a legal fiction as a result of [the transition to shelf registration]. Only the one or two page summary table at the front of the typical Form S-3 registration statement is today coherent to the average investor. Shelf registration and incorporation by reference really implied that disclosure to the market through [Exchange Act] filings replaced disclosure to individual investors through prospectuses. ==========================================START OF PAGE 17====== Since all mandated disclosure must either be filed with the Commission or delivered to investors at or prior to any sale of securities (and must be filed no later than any sale in a non-de minimis equity offering), the market and all investors will receive the information at the same time, or at an earlier point in time than under the current system. In addition, the issuer and other offering participants will have the same, or greater, liability for such information, as under the current system. The fact that all the mandated information is publicly available allows the issuer to include only the information most useful to an investor's understanding in the document physically delivered to investors, presented in a plain-English format that is readily accessible and understandable by the investor. The desired flexibility regarding prospectus delivery would be achieved under the pilot in a manner consistent with current prospectus delivery requirements of the Securities Act. Under company registration, issuers would be permitted to use incorporation by reference in a manner similar to that now available to seasoned companies to omit core, company-specific information from the prospectus delivered to investors. Subject to certain exceptions, a registered company could, but need not, use incorporation by reference to meet its prospectus delivery obligation with respect to the mandated transactional information as well. It can do so by incorporating, rather than physically delivering, all or portions of that information from any filed document such as a Form 8-K (whether mandated or filed solely for ==========================================START OF PAGE 18====== this purpose). This incorporation by reference could be into a document serving as the prospectus that is delivered at the time of confirmation of sale. Just as they currently have with respect to material company information, these issuers thus would have the flexibility to include all, some, or even none of the transactional information in the prospectus delivered to investors. In "routine transactions," the confirmation of sale itself could serve as the prospectus, so long as it expressly incorporates the necessary information on file with the Commission. Broker-dealer firms would satisfy their prospectus delivery obligations with respect to the distributed securities and aftermarket transactions in the same fashion.-[16]- This flexibility in the informational content of the prospectus to be delivered represents a further extension of current law. Since the adoption of incorporation by reference, the Commission has allowed company-related disclosure (which comprises a large portion of the mandated disclosure in a public offering) to be incorporated, rather than repeated in full, in the prospectus without any apparent loss of investor protection. Permitting transactional information in some instances also to be incorporated by reference amounts to a further incremental step. Just as issuers today often include a "recent developments" ---------FOOTNOTES---------- -[16]- See Section 4(3) of the Securities Act [15 U.S.C. 77(e)(3)]; Rules 174 and 434 under the Securities Act [15 C.F.R. 230.174 and 230.434]; Rule 15c2-8 under the Exchange Act [17 C.F.R. 240.15c2-8]. ==========================================START OF PAGE 19====== section in shelf takedown prospectuses, the Committee anticipates that issuers will continue to use their judgment in including any transactional information in the prospectus to the extent that public filing alone of such information might not afford adequate notice to a potential investor. The Committee believes that delivery of a prospectus as a marketing device in equity offerings likely would remain the common practice under the company registration system. Use of the prospectus would continue to depend on factors such as the nature and name recognition of the issuer, the size of the offering relative to the issuer's public float, the retail or institutional nature of the targeted investors, the price expectations of the issuer relative to the current market value and whether or not the public filing of the disclosure is effective dissemination to the potential investors. Because market forces reasonably can be relied upon to ensure the delivery of the appropriate level of information (at least in the case of seasoned issuers), a substantial argument could be made that there is no need to mandate prospectus delivery in any instance.-[17]- ---------FOOTNOTES---------- -[17]- In other jurisdictions such as Australia that have eliminated mandated specified line item disclosure requirements in favor of a general materiality standard, often prospectuses continue to contain most, if not all, of the same disclosure as when specific disclosure requirements were mandated. See Documents for Advisory Committee Meeting, June 15, 1995, Tab F (Study of Foreign Regulatory Processes). ==========================================START OF PAGE 20====== The Committee nevertheless concluded that physical delivery of a formal prospectus containing the transactional information should be required in certain circumstances. For the purposes of the pilot, the issuer will be required to deliver (rather than incorporate) the transactional information as part of the prospectus in the case of substantial offerings of equity securities (i.e., "non-routine" transactions). Those offerings, because of their size, are likely to alter substantially the information previously provided to the market and to involve significant oral and written selling efforts.-[18]- Accordingly, during the pilot, traditional prospectus delivery would be retained for offerings of voting securities in an amount in excess of (or potentially representing in excess of, in the case of warrants and convertible securities) 20 percent of the ---------FOOTNOTES---------- -[18]- The Committee considered a suggestion that the prospectus delivery requirement be imposed whenever "special selling efforts" were employed in the marketing of the offering. See Documents for Advisory Committee Meeting, July 26, 1995, Tab E (Letter dated June 27, 1995 from Richard Phillips to Commissioner Wallman). Special selling efforts could be evidenced by brokers' compensation beyond ordinary commissions and fees, as well as the distribution of selling materials. Although various members of the Committee agreed that heightened disclosure and liability should accompany special selling efforts (see Transcript of July 26, 1995 Advisory Committee Meeting at 256-57, 260), the Committee was concerned that the use of these concepts to identify transactions that require prospectus delivery would perpetuate existing confusion engendered by the use of that concept in other contexts under the federal securities laws, and that a simpler approach of the type recommended could satisfy the perceived needs to the same extent. Id. at 260-264. ==========================================START OF PAGE 21====== current market value of the issuer's voting securities held by non-affiliates. As today under shelf registration, the prospectus normally would be filed with, but would not be subject to prior review by, the Commission.-[19]- After reviewing data on the distribution of recent public offerings of equity as a percentage of an issuer's outstanding capital, the Committee chose 20 percent as the minimum delivery threshold.-[20]- In setting this threshold, the Committee sought to provide registered companies with flexibility to conduct a transaction (or series of transactions) that increase a company's public float by an amount that could be sold into the market without use of a formal prospectus -- for example, through regular trading transactions or placements of blocks -- without preparing a traditional prospectus. In these latter "routine" transactions, investors least expect the information traditionally provided in a prospectus to make an investment decision.-[21]- Rather, absent unique circumstances ---------FOOTNOTES---------- -[19]- The one exception would be extraordinary transactions in equity securities, exceeding 40 percent of the issuer's existing capital base, which would require the filing of a post-effective amendment to the company registration statement and would be subject to staff review. -[20]- See Documents for Advisory Committee Meeting, November 21, 1995, Tab D. -[21]- See Coffee, Re-engineering Disclosure, supra n.15, at 1145 (stating Milton Cohen's view that "[b]ecause the [Exchange] Act creates a system of continuous, periodic disclosure, the existence of this system profoundly reduces the need for transaction-specific disclosure at the time when (continued...) ==========================================START OF PAGE 22====== regarding the transaction, investors will tend to focus on the company-related disclosure already disseminated to the market and reflected in the company's stock price. In other words, consistent with the guideline articulated by Milton Cohen, the appropriate delivery threshold would allow those transactions that today involve delivery of a prospectus only at the time of the confirmation, and not as part of the marketing process, to proceed without any formal delivery of a prospectus.-[22]- Conversely, where transactional disclosure is required to be delivered in a prospectus, the Committee feels strongly that it should be delivered to investors in sufficient time to influence and inform their investment decision. The Committee therefore determined that any prospectus required to be delivered in these substantial equity offerings should be delivered prior to the time the investor determines to purchase.-[23]- ---------FOOTNOTES---------- -[21]-(...continued) an issuer later seeks to sell its securities. Logically, a corporate issuer seeking to sell securities under a continuous disclosure system would only be required to disclose any additional material information that it had not previously disclosed pursuant to the continuous disclosure system.") -[22]- Cohen, supra n.2, at 1386; see also Linda C. Quinn, Reforming the Securities Act of 1933 - A Conceptual Framework, INSIGHTS at 25 (January 1996) (the "Quinn Speech"). -[23]- Cf. Rule 15c2-8 under the Exchange Act [17 C.F.R. 240.15c2-8] (prospectus required to be delivered 48 hours prior to sending the confirmation of sale in IPOs which may still be after the investor agrees to the sale). The Committee recognizes that the prospectus delivered at the time of sale (continued...) ==========================================START OF PAGE 23====== Because of the Committee's belief that it should be investors' informational needs that dictate the need for a prospectus as a selling document and the content of that prospectus,-[24]- and that the elimination of regulatory mandates with respect to seasoned issuers would not result in less useful information being provided to investors, the Committee was comfortable in establishing a generous threshold in order to preserve maximum issuer flexibility.-[25]- Nevertheless, the determination of the appropriate threshold is best made with the benefit of the comment process that ---------FOOTNOTES---------- -[23]-(...continued) in these non-routine transactions will resemble preliminary prospectuses (i.e., "red herring") in that price-related and other current information normally would have to be omitted and provided on a supplemental basis. That information would otherwise be available, in any event, through the filing of the transactional Form 8-K at the time of sale. -[24]- The Committee has been informed on an anecdotal basis that disclosure documents in Rule 144A placements closely resemble prospectuses in registered offerings, even though there are no Commission-specified disclosure requirements in a Rule 144A placement other than under a general antifraud standard. -[25]- Based upon data reflecting market capitalization, rather than public float, approximately 68 percent of underwritten repeat offerings of common stock in 1992-1994 would fall below the 20 percent recommended threshold for mandatory prospectus delivery. Thus, prospectus delivery would not have been required in over two-thirds of such offerings. If the threshold were lowered to 10 percent, prospectus delivery would have been eliminated for only 30 percent of such transactions. See Figure 6 in the Addendum to Appendix A of the Report. ==========================================START OF PAGE 24====== accompanies Commission rulemaking proceedings, and could be significantly lower or greater than 20 percent-[26]- and involve factors other than a percentage of the public float.-[27]- Indeed, this threshold could be increased and combined with the extraordinary transaction tier with resulting simplification of the system. While not formally recommended for the pilot, the Commission may wish to consider whether similar thresholds should be developed for offerings of senior non-voting equity securities as well as non-investment grade debt. Where required to deliver a prospectus, the issuer still would be permitted to take advantage of incorporation by reference of company information to the same extent as permitted today, and still would be allowed to include any additional information it deems material in the prospectus. Similarly, delivery of the statutory prospectus could be accomplished in the same manner as permitted today, provided the prospectus was ---------FOOTNOTES---------- -[26]- In France, Germany and the United Kingdom, no prospectus is required if the offering is for less than 10 percent of an existing class listed on an exchange and certain other conditions are met. See Documents for Advisory Committee Meeting, June 15, 1995, Tab F (Study of Foreign Regulatory Processes). -[27]- See, e.g., Exchange Act Rel. 37094 (April 11, 1996) [61 FR 17108 (April 18, 1996)] (proposing use of Average Daily Trading Volume as basis for applicability of proposed Regulation M). See also NYSE Listed Company Manual, 312(c)(i) (July 1989). ==========================================START OF PAGE 25====== received in time to influence the investment decision.-[28]- Thus, in these circumstances, the prospectus would be expected to contain, at a minimum, the same level of information found in a prospectus used today by a seasoned issuer in an offering conducted on Form S-3. Other circumstances in which physical delivery of transactional information, rather than incorporation by reference, would be necessary, include: Information Necessary To Avoid Misleading Investors Just as, and to the same extent as, under the current shelf system, reliance on incorporation by reference into the prospectus or selling materials would not be appropriate where statements appearing in the physically delivered materials would be rendered misleading by the absence of information appearing only in filed documents.-[29]- Similarly, incorporation by reference of material developments that have not been disclosed sufficiently in advance of the use of the prospectus to allow the market to access and absorb the information would not be appropriate. Use of Selling Materials Under the current system, to the extent written selling materials that do not satisfy prospectus disclosure requirements are distributed to investors in the course of the offering, a prospectus containing the mandated information has to be delivered prior to or simultaneous with the materials.-[30]- Under company registration, an ---------FOOTNOTES---------- -[28]- See, e.g., Rules 430A and 434 under the Securities Act [17 C.F.R. 230.430A and 230.434]. -[29]- See Proposed Revision of Regulation S-K and Guides for the Preparation and Filing of Registration Statements and Reports, Securities Act Rel. 6276 (December 23, 1980) [46 FR 79 (January 2, 1981)] . -[30]- Section 5(b) of the Securities Act [15 U.S.C. 77e(b)] prohibits the use of any prospectus to sell a security even after the registration statement is declared effective, unless the prospectus contains all the information mandated (continued...) ==========================================START OF PAGE 26====== issuer could avoid delivery of two different documents by either including or incorporating by reference the required information into the selling materials and treating the selling materials as the statutory prospectus. That approach would require the materials to be filed and subject them to liability under Section 12(a)(2) of the Securities Act (whereas generally such documents are subject only to fraud liability under the current system). The Committee recommends that, after a period of time, the Commission revisit the circumstances under which physical prospectus delivery requirements should be retained.-[31]- Under the current system, prospectuses frequently are not provided to investors until after an investment decision is made, do not carry the appropriate level of liability, and do not inform the market at an appropriate time. Under company registration, these issues are resolved through enhanced and ---------FOOTNOTES---------- -[30]-(...continued) by the Act and Commission rules. Selling materials are excluded from the definition of prospectus under Section 2(10) of the Act [15 U.S.C. 77b(10)] only if their delivery is accompanied or preceded by a statutory prospectus. -[31]- The Commission views delivery through electronic means as satisfying the delivery or transmission requirements of the federal securities laws if such distribution results in the delivery to the intended recipients of the required information -- the means are not relevant. See Use of Electronic Media for Delivery Purposes, Securities Act Rel. 7233 (October 6, 1995) [60 FR 53458 (October 13, 1995)]; see also Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for Delivery of Information; Additional Examples Under the Securities Act of 1933, Securities Exchange Act of 1934, and Investment Company Act of 1940, Securities Act Rel. 7288 (May 9, 1996) [61 FR 24644 (May 15, 1996)]. ==========================================START OF PAGE 27====== accelerated transactional filing requirements. Consequently, it may be possible to dispense with a physical prospectus delivery requirement in all but extraordinary circumstances.-[32]- For the present, however, the Committee was not prepared to conclude that delivery of prospectus information to the market at large through filed documents is an adequate substitute for physical delivery to all investors in all cases, and thus determined to recommend that delivery of a traditional prospectus still be required to be made to non-accredited investors in non- routine transactions. The Committee was concerned that individual investors may not have access to alternative information sources for obtaining information on file with the ---------FOOTNOTES---------- -[32]- A number of countries do not require that the prospectus be delivered to offerees and purchasers other than by publication. France, Germany and the United Kingdom call for either the publication of the prospectus, with investors offered an opportunity to request additional information, or merely the publication of the availability of the prospectus, including specification of the place where investors may go to obtain a prospectus. In addition, subject to certain conditions, in Germany and the United Kingdom, for repeat offerings of less than 10 percent of the market capital of a previously listed security, the prospectus requirement has been eliminated. If such securities also are to be listed, the relevant exchange still must approve the additional listing application, but no disclosure document is required as part of the applications process. However, the United Kingdom does require publication of the number and type of securities to be listed as well as the circumstances of their issuance. France has a similar exemption, but imposes far more conditions on its use. See Documents for Advisory Committee Meeting, June 15, 1995, Tab F (Study of Foreign Regulatory Processes). ==========================================START OF PAGE 28====== Commission, even if access to such filed information is provided earlier via these sources than the more traditional means used under the current system.-[33]- In all instances, physical prospectus delivery would not be required to be made to accredited investors. Such investors would benefit under company registration from access to information required to be filed with the Commission earlier than it is now required to be provided to any investor under the current Form S-3 primary shelf offering process. Moreover, such accredited investors are in a position to have such information delivered directly to them if they so prefer. ---------FOOTNOTES---------- -[33]- See Transcript of May 8, 1995 Advisory Committee Meeting at 233-236. ==========================================START OF PAGE 29====== B. Role of the Commission and Other Gatekeepers or Monitors Outside gatekeepers -- the regulators, lawyers, underwriters, accountants and other professionals -- are critical to the integrity of the securities markets. Current offering procedures allow an issuer to market securities with little notice and without adequate opportunity for meaningful review and investigation at the time of the offering by the traditional gatekeepers. The Committee thus explored means to enhance their roles. Company registration will facilitate the due diligence process by reordering and rationalizing the gatekeeping functions in a manner that will improve their effectiveness in ensuring the dissemination of quality disclosure to the market, not only in connection with public offerings, but on a continuous basis as well. Company registration would make the necessary adjustments to this traditional function by encouraging ongoing monitoring of the issuer's disclosures by the parties in the best position to perform that function. 1. The Commission Review Process As noted, neither the Form C-1 nor the transactional disclosure filed with the Commission and publicly disseminated at the time of the offering normally would be subject to staff review prior to the commencement of the offering. This approach would not reflect a significant change in current Commission administrative practice. The Commission already has shifted a significant part of its gatekeeping function to reviewing company related and financial information in Exchange Act reports, although a public offering remains a selection factor even for seasoned issuers. As reported in Table 2 to Appendix B, only approximately 16 percent of filings by seasoned issuers on Form ==========================================START OF PAGE 30====== S-3 are reviewed by the staff.-[34]- With regard to securities sold off an already effective shelf registration statement, prospectus supplements disseminated upon takedown are never subject to staff pre-review. Some have argued that the mere possibility that an offering could be selected for review remains an important deterrent to inadequate or misleading disclosure practices. The Committee concluded, however, that this deterrent effect comes at the cost of significant uncertainty in the timing of securities offerings that often lead even seasoned issuers to resort to alternative capital-raising techniques that generally offer less investor protection. Even with the adoption of the universal shelf system, issuers still are drawn to alternative markets. This is apparently due in part to issuer demand for immediate access to the market, which could be delayed by the potential review of the Form S-3 shelf registration statement. In the Committee's view, the significant deterrent to the sale of securities with less than complete and accurate information would be preserved for these seasoned issuers through Commission staff review of transactional documents at the time it reviews the company's Exchange Act reports, just as is currently ---------FOOTNOTES---------- -[34]- In FY 1995, of the 3900 reporting companies reviewed, two-thirds were reviewed in an Exchange Act, rather than transactional, context. Of the reporting issuer reviews in a transactional context, approximately half included a review of the registrant's Exchange Act reports. See Quinn Speech, supra n.22, at 30 n.21. ==========================================START OF PAGE 31====== the practice regarding takedown prospectuses for offerings of securities off already effective shelf registration statements. As with the current system, the presence of significant financing or acquisition activity should remain a factor considered by the Commission staff in determining whether to select an issuer for review. The prospect that the Commission staff could issue significant comments and insist on material revisions to disclosures already relied upon in connection with an offering of securities (a possibility that also exists today) should provide adequate incentive to ensure that the company's disclosure is of the highest quality. The Committee nevertheless determined, at least for purposes of the pilot, that extraordinary distributions of equity securities by registered companies should remain potentially subject to staff pre-review. Offerings of voting securities exceeding 40 percent of the existing public float should be required to be filed on an amendment to the Form C-1 registration statement that would not become effective absent acceleration by the staff. In addition, the likelihood of staff review of proxy materials in connection with extraordinary transactions will continue to ensure that transactional reviews take place in those cases where investor rights are most likely to be affected.-[35]- For this reason, the Committee considered ---------FOOTNOTES---------- -[35]- The New York Stock Exchange requires, as part of its listing requirements, shareholder approval for the issuance of stock with voting power equal to or in excess of 20 percent of the voting power (continued...) ==========================================START OF PAGE 32====== limiting staff pre-review to mergers, acquisitions, and other types of restructurings, but not straight financings. However, the Committee determined that such a distinction would be difficult to administer. Moreover, significant financings can cause a fundamental change in the nature of the company depending on the use of proceeds and, at the extreme, could resemble an initial public offering by a new enterprise. If other criteria exist for identifying circumstances where staff review of a transaction may be particularly beneficial to investors (for example, offerings by distressed issuers), yet afford issuers predictability regarding whether the filing will be reviewed, they should be explored. There remains a concern that an issuer planning an offering under the company registration system will discover during the planning process that the staff has selected its Exchange Act filings for review. The issuer then would have to determine whether to delay the offering, and thus risk the closing of a market window, or go to market with the risk that the staff may have significant comments that may require revisions to existing disclosure or additional disclosure. Issuers face this dilemma today in deciding whether to proceed with a shelf offering after learning that the staff has commenced a review of its Exchange Act filings. To address this concern in part, the Committee ---------FOOTNOTES---------- -[35]-(...continued) outstanding, in other than public offerings for cash. NYSE Listed Company Manual, 312.03(c)(i) (July 1989). ==========================================START OF PAGE 33====== believes that the Commission could establish a procedure under which issuers could seek a review, possibly on a nonpublic basis, when planning to go to market.-[36]- By requesting a review prior to the offering, registered companies would benefit by minimizing the chance that the staff would select their filings for review on the eve of a planned offering. Such a procedure may be particularly useful where a transaction poses novel disclosure and accounting issues. 2. The Underwriter The Committee was advised of the concerns of the underwriting community that the adoption of a company registration scheme -- and the wider use of the shelf registration system, particularly for equity and non-investment grade debt -- could further erode their ability to conduct effective due diligence. Consideration was given to what measures, if any, are necessary to ensure ample opportunity for underwriter due diligence. These measures could serve either as a "speed bump" to ensure that underwriters are engaged early enough in the offering process to provide an adequate opportunity to review the issuer's disclosures or as a "focal point" to ---------FOOTNOTES---------- -[36]- This process could be similar to that afforded confidential merger proxies, as well as Securities Act filings of foreign issuers when necessary to preserve the confidentiality of a transaction prior to the marketing of the offer consistent with home country practice. See Exchange Act Rule 14a-6(e)(2) [17 C.F.R. 240.14a-6(e)(2)]. See also Transcript of June 15, 1995 Advisory Committee Meeting at 39 (statement of Edward Greene). ==========================================START OF PAGE 34====== concentrate attention on due diligence responsibilities. One suggestion required the issuer to hire or select the underwriters eligible to participate in the offering at least three days prior to the offering in the case of underwritten offerings of more than 10 percent of the issuer's voting securities.-[37]- The Committee concluded that this suggestion would impose an artificial burden on the offering process, and that the parties are in a best position to determine the amount of time necessary to conduct adequate due diligence. Consequently, the Committee rejected the notion of a "speed bump" that artificially disrupts the process. The Committee was informed by underwriters that the requirement to file a Form 8-K at the time of the offering containing the transactional disclosure and any material company-related updating disclosure in connection with equity takedowns in excess of a certain percentage of the equity outstanding would help to "focus" the due diligence inquiries by underwriters. This requirement also would ensure that the market is informed of both the offering and of the transactional and material updating information, and that such information is subjected to the liability provisions of ---------FOOTNOTES---------- -[37]- In his 1985 article, Milton Cohen proposed to address this question by imposing a waiting period of at least five days, at least in equity offerings if not all offerings, unless the underwriter joins in a request for acceleration of that period. Milton H. Cohen, The Integrated Disclosure System -- Unfinished Business, 40 Bus. Law. 987, 994 (1985)("Cohen, Unfinished Business"). ==========================================START OF PAGE 35====== Securities Act Sections 11 and 12(a)(2). For these reasons, the Committee recommends this type of Form 8-K filing for both company registration and shelf registration equity offerings of a non-de minimis amount. Moreover, the separate recommendations that information regarding material developments either be delivered in a prospectus or be on file prior to its incorporation by reference into the prospectus, as well as the proposal to deliver the prospectus prior to sale in the case of substantial equity offerings, should provide the underwriter with sufficient additional time to investigate the disclosures. Finally, the proposed guidance regarding due diligence practices (discussed in greater detail below) likewise should create incentives for issuers and underwriters to adopt disclosure practices that involve the parties best able to ensure the accuracy of the disclosures in the due diligence process. The proposed guidance should assist the underwriter in performing due diligence by identifying the parties to whom the underwriter can turn with inquiries regarding specific aspects of the issuer's disclosure. 3. The Auditor Under the company registration system, just as under today's shelf registration system, an auditor's consent to the use of its report, dated as of, or shortly before, the effective date of the registration statement (as updated by the filing of audited financial statements on Form 10-K) would have to be on file with ==========================================START OF PAGE 36====== the Commission at the time of the offering.-[38]- Consistent with current practice with respect to the shelf, the auditor could consent to incorporation of its audit report into the company registration statement at the time the Form 10-K containing the auditor's report is filed. That consent, unless withdrawn by the auditor, would be applicable to all offerings pursuant to the Form C-1 until the issuance of a new set of audited financial statements, or other filings are made that have the effect of resetting the effective date of the registration statement. Alternatively, the auditor could determine that its consent could be filed and currently dated for each specific issuance of securities, or conditions could be attached to its use, all as permitted under current practice. Consideration was given whether to mandate further auditor review of the Form 10-Q's interim financial statements at the time of their filing, rather than as part of the annual audit. A special committee of the AICPA recently called for greater association by independent accounting firms with the non-audited information of their corporate clients as a means to enhance the value of business ---------FOOTNOTES---------- -[38]- Auditors generally may not provide "prospective consents," or consents that are provided significantly in advance of the effective date of the registration statement. Under Section 11(b)(3)(B) of the Securities Act, the adequacy of an auditor's due diligence inquiry will be judged "at the time such part of the registration statement became effective . . . ." [15 U.S.C. 77k(b)(3)(B)]. ==========================================START OF PAGE 37====== reporting to end-users.-[39]- Many seasoned public companies now engage their outside auditors to perform a review of interim financial information in accordance with Statement on Auditing Standards ("SAS") No. 71.-[40]- Pursuant to this standard, an independent accounting firm will make inquiry regarding the company's internal control structure and any significant changes therein since the most recent financial statement audit or interim review to determine the possible impact on the preparation of interim financial information, and will apply analytical procedures to such information to "provide a basis for inquiry about relationships and individual items that appear to be unusual."-[41]- For purposes of the pilot, the Committee did not believe it necessary to mandate use of SAS No. 71 reviews by registered companies. First, there already appears to be growing use of SAS ---------FOOTNOTES---------- -[39]- See generally Improving Business Reporting - A Customer Focus: Meeting the Needs of Investors and Creditors, Comprehensive Report of the Special Committee on Financial Reporting, American Institute of Certified Public Investors (1994) (the "Jenkins Committee Report"). -[40]- The Committee was informed that at least one major accounting firm requires a review of interim financial information as a condition to their accepting a SEC audit client. See Transcript of September 29, 1995 Advisory Committee Meeting at 192 (statements of Mr. Elliott). -[41]- SAS No. 71.13. Rule 436 under the Securities Act states that an independent accountant will not be deemed to have "expertized" a report on unaudited interim financial information [17 C.F.R. 230.436(c)]. ==========================================START OF PAGE 38====== No. 71 reviews by seasoned issuers.-[42]- Moreover, for larger, more seasoned companies, auditors do not visit the company just once or even four times a year, but rather can be there "virtually continuously."-[43]- By clarifying that SAS No. 71 reviews and any other more detailed reviews of interim information are appropriate factors to be considered in determining the proper scope of underwriter and outside director due diligence, the Committee anticipates that there will be adequate incentives to adopt the practice.-[44]- As a ---------FOOTNOTES---------- -[42]- A recent survey of approximately 25 percent of the firm's SEC clients conducted by Price Waterhouse revealed that "most large companies -- i.e., those which would initially be eligible for the company registration process -- already have some kind of auditor involvement with their quarterly data." Letter from Arthur Siegel, Price Waterhouse LLP, to Steven M.H. Wallman, Securities and Exchange Commission, dated July 3, 1996 (the "Price Waterhouse Survey"). -[43]- Transcript of September 29, 1995 Advisory Committee Meeting at 192 (statements of Mr. Elliott). -[44]- In debating whether any form of review of interim financials, or even non-financial information, by auditors should be mandated as a condition of opting into the company registration system, the Committee was concerned about imposing undue burdens on issuers in the form of additional costs. In 1989, the Commission considered, among other matters, revising its rules to require interim financial information of registrants be reviewed by independent auditors before such information was filed with the Commission, and requested public comment on both the perceived need for such revisions and any incremental costs and benefits of imposing such requirement. In a comment letter from Arthur Andersen & Co., the firm estimated that the incremental cost of mandating timely interim reviews to a majority of (continued...) ==========================================START OF PAGE 39====== result, the auditor's gatekeeping function would be enhanced by causing its reviews of interim financial information to occur on a more current basis when corrections can be made in filed reports before they are disseminated to the public, rather than after the close of the fiscal year.-[45]- ---------FOOTNOTES---------- -[44]-(...continued) its clients who already had some form of timely review performed was in the range of 5-20 percent. For those clients that did not already have a timely review performed, incremental costs may be higher. The larger the client, the lower the incremental cost in percentage terms. In addition, Arthur Andersen stated that, notwithstanding the burden of additional cost, the benefits of mandating such reviews on smaller companies would be proportionately greater because of their generally less sophisticated accounting systems. In Arthur Andersen's view, while the performance of interim reviews "would not detect reporting problems to the same extent of an audit, ... it would enhance the overall quality of smaller registrants' financial information and reduce the possibility of the issuance of misleading interim reports." Letter from Richard Dieter, Arthur Andersen & Co., to Jonathan G. Katz, Secretary, Securities and Exchange Commission, dated September 12, 1989. A more recent survey conducted by Price Waterhouse estimated that, for those clients for which full, timely SAS 71 reviews are not currently conducted, the average cost per quarter increase in annual audit fees if such reviews were to be conducted was 2-7 percent of annual audit fees, assuming a report is issued only to management and the board of directors. The average cost would increase to the extent the report was issued to underwriters or shareholders. Price Waterhouse Survey, supra n.42. -[45]- See Transcript of September 29, 1995 Advisory Committee Meeting at 193 (statements of then SEC General Counsel Simon Lorne). ==========================================START OF PAGE 40====== The auditor also can serve an important function at the time of the offering. In many cases, the underwriter or its counsel will discuss the issuer's financial statements with the issuer's outside auditing firm, and will request comfort from that firm with respect to financial information contained in the prospectus. Since mid-1993, the accounting profession has followed the guidance prescribed in SAS No. 72 in this context. An SAS No. 72 engagement relating to a registered public offering may encompass either or both the audited financial statements and unaudited financial data set forth in the prospectus. The auditor may provide positive assurance on compliance with applicable Commission rules and regulations (such as Regulations S-X or S-K) as to financial statements and schedules that the accountant itself has audited. Finally, an auditor can perform an additional gatekeeping function at the time of the offering when asked to furnish or update a consent to the use of his or her report. Prior to providing such a consent, an auditor makes inquiries and performs other procedures under SAS No. 37 to satisfy itself that events subsequent to the date of the annual audited financial statements do not indicate that adjustments to those statements are necessary. II. Company Eligibility When fully implemented, the benefits of company registration would be extended to virtually all public companies that previously had conducted a public offering of their securities. The concepts of company registration, however, will be tested under a pilot open only to certain seasoned companies. The exact ==========================================START OF PAGE 41====== criteria for participation in the system and what, if any, additional conditions would be necessary for smaller issuers, will be determined based on experience with the pilot. The Advisory Committee considered several approaches for defining which companies would be eligible for company registration. The Committee's goal was to extend the benefits of company registration to as many companies as possible, yet preserve the current scheme in those instances where it has proven cost-effective and beneficial to investors. For the reasons outlined below, for the purposes of the pilot, the Committee ultimately settled upon the following eligibility requirements: completion of an initial public offering, a two- year reporting history, $75 million public float, and a class of securities listed on the New York Stock Exchange, the American Stock Exchange, or the Nasdaq-NMS stock market. The Committee believed that the current process for initial public offerings ("IPOs") generally works well in assisting a company in the transition from a private to a public company. Although in many respects there may be ways to lower the transaction costs and delays inherent in the "going-public" process, the Committee determined that those issues should be addressed separately from the consideration of a company registration process.-[46]- In the Committee's view, the ---------FOOTNOTES---------- -[46]- An example of such a measure would be the Commission's current proposal to allow issuers to "test the waters" in connection with an IPO. See Solicitations of Interest Prior to an Initial Public Offering, Securities Act Rel. 7188 (June (continued...) ==========================================START OF PAGE 42====== current filing and staff review process is instrumental in assisting the private company to acquaint itself with the disclosure obligations of a publicly owned company. The delay inherent in the process allows the company's advisers to help its management put its books and records in order (including obtaining audited financial statements) and resolve any insider transactions or arrangements that may be inappropriate for a public company. In the Committee's view, there is no alternative to full due diligence by all outside advisers and gatekeepers in the context of an IPO. For these purposes, the Committee recommended that an IPO be defined as the first registered offering of securities by an issuer.-[47]- Thus, even a company that has been subject to reporting requirements for a period of time because its equity is held by more than 500 record holders and it has more than $10 million in assets,-[48]- or it has securities listed on an exchange,-[49]- would not be eligible for company registration until it has made at least one registered offering ---------FOOTNOTES---------- -[46]-(...continued) 27, 1995) [60 FR 35648 (July 10, 1995)]. -[47]- A registered offering by a company that previously had conducted registered offerings and had been a reporting company, but thereafter went private and ceased reporting, would be considered an IPO for these purposes. -[48]- Section 12(g) of the Exchange Act [15 U.S.C. 78l(g)] and Rule 12g-1 [17 C.F.R. 240.12g-1]. -[49]- Section 12(b) of the Exchange Act [15 U.S.C. 78l(b)]. ==========================================START OF PAGE 43====== of securities under the Securities Act. While a company filing a Form 10 under the Exchange Act to register a class of securities is subject to substantially the same disclosure requirements as a Securities Act registrant, and a Form 10 normally is selected for staff review, the level of professional outside involvement and due diligence may be significantly less absent an offering of securities and the potential application of the strict liability provisions of Section 11 of the Securities Act. During the pilot, and perhaps in the initial stages of full implementation, the company registration system would be voluntary; eligible companies could opt in as they desired. Once this election is made, a company could opt out by withdrawing its registration, but it would not be eligible to use the system again for a specified period of time (two years is recommended). This voluntary approach offers the benefit of providing a market test for the system. Once experience is gained with company registration, the benefits of company registration should be made available to virtually all publicly traded companies to conduct repeat offerings. One of the advantages of the company registration system is that, by virtue of the integral enhancements to the disclosure process, the system will allow the extension of streamlined access to the capital markets to companies currently not eligible to use shelf registration. Under the universal shelf registration process, large companies currently have significant flexibility. Thus, if eligibility for company ==========================================START OF PAGE 44====== registration were limited to large companies, the benefit for issuers aided by the system would not be as great as if the system were extended to other issuers. The Committee recognizes, however, that extension of the system beyond S-3 eligible issuers may require additional disclosure enhancements or conditions, depending upon the experience with the pilot. For example, any smaller companies permitted to take advantage of the company registration process that have little market following and therefore a less efficient market for their securities might be required to continue to comply with traditional prospectus delivery requirements for all public offerings regardless of the amount offered, or to undergo staff review of audited financial statements prior to their use. Those determinations necessarily can be made only by the Commission on the basis of experience gained under the pilot. For that reason, the Committee concluded that the system should be phased in gradually, starting with the pilot under which only larger, more seasoned companies would be eligible to participate. In this manner, the system could be tested and fine-tuned with the help of those companies most experienced with the disclosure responsibilities of public companies and with access to the most experienced counsel and underwriters. Initially, the Committee considered using for pilot eligibility the existing standards established by the Commission ==========================================START OF PAGE 45====== for eligibility to register securities on Form S-3.-[50]- The Committee concluded, however, that additional criteria would be useful at the pilot stage. Because the company registration system would place greater reliance on the quality of the issuer's Exchange Act reports, the Committee determined that only companies with a reporting experience of at least two years would be eligible for participation in the system. In the view of the Committee, it often takes at least two years following an IPO for a company and its management to become fully comfortable with the disclosure obligations of a public company and to have all their mechanisms for gathering and disseminating information in place and properly functioning.-[51]- The Committee also concluded that initial pilot eligibility should be limited to companies listed on the New York Stock Exchange or The American Stock Exchange, or quoted in the National Market System of the Nasdaq Stock Market. Limiting the eligibility to listed companies has the benefit of adding the overlay of listing standards, including the agreement to provide ---------FOOTNOTES---------- -[50]- Eligibility for the shelf is generally limited to companies eligible to register securities on the Form S-3 short form registration statement. S-3 companies generally include only those that have a $75 million public float; one-year reporting history; and are current with respect to their reporting requirements and certain fixed obligations. With respect to equity, the public float requirement is eliminated for secondary offerings. -[51]- Transcript of September 29, 1995 Advisory Committee Meeting at 13-18. ==========================================START OF PAGE 46====== prompt disclosure to the markets of material developments. Such a criterion is useful at the pilot stage, because it would minimize the amount of coordination with the states needed because of the common exemption under state "Blue Sky" laws for listed companies. After incorporating each of these criteria, based upon information available to the Committee staff, roughly 30 percent of all reporting companies should qualify for the pilot.-[52]- To be eligible, a company must adopt the enhanced disclosure practices discussed below. During the pilot, noncompliance with the issuer eligibility conditions or any of the disclosure enhancements as of the time the issuer's Annual Report on Form 10-K update is filed would result in loss of eligibility to make offerings pursuant to the company registration form. Similarly, the issuer must be current with respect to its Exchange Act reporting obligations at the time of the offering. Voluntary or involuntary withdrawal from the system would render the issuer ---------FOOTNOTES---------- -[52]- The Committee had considered whether eligibility should be limited to a senior class of S-3 companies that have a public float of $150 million (the threshold used prior to 1992), rather than $75 million. Based upon data available to the Committee staff, this increase over the S-3 standard would reduce by one-third the percentage of reporting companies eligible for the system as compared to the S-3 standard. Because the $150 million level of capitalization may prevent a fair test for extending the system beyond S-3 eligible issuers, the Committee determined to retain the $75 million eligibility standard. ==========================================START OF PAGE 47====== ineligible to elect back into the system for a period of two years. Consideration also was given to whether the degree of research coverage by independent analysts should be an eligibility criterion. This criterion is not recommended by the Committee in light of concerns with defining what constitutes "research coverage." Several commenters also suggested that eligibility be limited to companies with an investment grade rating for senior securities. Because many companies do not obtain ratings, or do so only on the basis of credit enhancements, and may have different ratings for different classes of senior securities, this factor was not believed to be a useful determinant of the quality of the issuer's disclosures or otherwise consistent with the concept of company registration. Further, consideration was given to whether eligibility should be extended to closed-end investment companies. Registered investment companies are subject to a different set of reporting requirements under the Investment Company Act of 1940 and the rules and forms adopted thereunder. In the Committee's view, the company registration system may not be that useful for these companies. Accordingly, at least for the purposes of the pilot, the Committee did not recommend inclusion of closed-end funds, but left the issue to the Commission for any further review it deemed necessary. ==========================================START OF PAGE 48====== For similar reasons, foreign private issuers generally would be eligible for the pilot if they file the same forms and meet the same disclosure requirements as domestic companies. Since many foreign regulatory schemes do not require the filing of quarterly reports and any required semi-annual reports generally are based upon home country disclosure rules and practices,-[53]- it is possible that participation by these companies in the pilot may not be appropriate absent their providing disclosure comparable to domestic companies. Nevertheless, the Committee urges the Commission to consider whether a practice analogous to the current practice of some foreign issuers using the shelf on Form F-3 to provide reconciled interim financials on Form 6-K on a semi-annual basis, and incorporating those financials into the shelf registration statement, would suffice for company registration. ---------FOOTNOTES---------- -[53]- Under the foreign integrated disclosure system, reporting foreign private issuers file an annual report on Form 20-F. All other interim financial information required to be made public under home- country law is based upon home-country disclosure rules and practices. Consequently, foreign private issuers are not required to file quarterly financials on Form 10-Q or current reports on Form 8-K in accordance with U.S. disclosure requirements. See Exchange Act Rule 13a-16 [17 C.F.R. 240.13a-16]. ==========================================START OF PAGE 49====== III. Transactions Covered All sales of securities by a registered company will be afforded the same legal status as a registered offering of securities under the current scheme, thereby eliminating or greatly reducing the need for resale restrictions and other artificial restraints, such as those necessitated by the concepts of gun-jumping, restricted securities, affiliate sales, integration of offers, general solicitation, and flowback of offshore offerings. Under the voluntary pilot, companies would be provided the choice of obtaining these benefits by treating all offers and sales as covered by the company registration statement, or choosing to preserve the option to engage in exempt transactions at the cost of continued regulatory restrictions on resales. A. Affiliate and Underwriter Resales With limited exceptions, the company registration system would be available for all offerings of any securities by eligible companies. Similarly, sales by affiliates and by any person acting for a registered company or its affiliates would be covered by the Form C-1. The Securities Act addresses resales of securities primarily as a means to prohibit the distribution of securities of issuers for which there is inadequate information available to the public,-[54]- and to protect the integrity of the transactional registration process. This concern is particularly important when the issuer is not yet a public company and private sales and redistributions could serve as a means of developing a trading market in the security without the issuer being subjected to the registration process. It has long been recognized that this concern is of less importance where the ---------FOOTNOTES---------- -[54]- See Preliminary note to Rule 144 [17 C.F.R. 230.144]. ==========================================START OF PAGE 50====== issuer already is a reporting company and is currently subject to ongoing disclosure requirements.-[55]- 1. Sales of Restricted Securities A company registration system would further alleviate these concerns by eliminating the notion of exempt private placements and restricted securities altogether. Under full company registration, regardless of the nature of the transaction in which securities were initially sold by the issuer or its affiliates, there would be no need to impose resale restrictions on outstanding securities. All sales by registered companies and their affiliates made under Form C-1 would have the same legal status and carry the same or higher liability and investor protections as registered offerings do today. For that reason, the provisions of Rule 144 governing resales of restricted securities would not be necessary since all shares would be registered if issued by a registered company. A purchaser in the secondary market would be better protected under the company registration scheme, especially given the more current and reliable information being provided by the issuer pursuant to the various disclosure enhancements. Because all issuer and affiliate sales would be deemed to be made under the ---------FOOTNOTES---------- -[55]- See Cohen, supra n.2, at 1395. ==========================================START OF PAGE 51====== Form C-1 (where a company has opted into full company registration-[56]-), an issuer cannot use indirect sales through a conduit as a means to distribute securities without registration and disclosure, nor as a means to escape liability. All securities issued under the company registration system would be subject to Section 11 liability for any misleading statements or information in the issuers' public reports that are incorporated by reference into the registration statement at the time of original issuance by the issuer. This liability would run to any purchaser that can trace the security back to the misleading registration statement. Indeed, in the case where it can be demonstrated that the seller was a mere "strawman" for the issuer and was selling on its behalf, the resale itself will be considered an issuer transaction made pursuant to the registration statement. Since all securities would be deemed registered upon issuance under company registration, the Committee has determined that a safe harbor from the broad definition of "underwriter" in Section 2(11) of the Securities Act should be adopted for purposes of resales of securities issued by a registered company. The safe harbor would limit the application of the underwriter ---------FOOTNOTES---------- -[56]- As noted (supra p. 5-6), a registered company opting for full participation in the system would have the choice whether to sell non-convertible debt securities within the system. However, no such choice would be available for equity securities and securities convertible to equity -- all such securities issued by the fully participating company must be sold pursuant to the company registration system. ==========================================START OF PAGE 52====== concept to persons engaged in the business of a broker-dealer, whether or not registered as such (including banks not required to register as a broker-dealer), who participate in the distribution of securities by an issuer or an affiliate.-[57]- The Commission may wish to consider whether it would be helpful to specify a time after which a broker-dealer would no longer be deemed a participant in the distribution (e.g., after it has sold out its allotment or the expiration of six months, whichever is earlier), especially if the Commission otherwise shortens the period in which a distribution will be deemed to occur. The purpose of this provision would be to ensure that only the underwriting firms participating in the offering incur responsibility under Section 11 liability and due diligence provisions, while providing more certainty as to when resales may freely take place. ---------FOOTNOTES---------- -[57]- The use of a narrower definition of underwriter for the purpose of resales of securities sold under the company registration system is appropriate, since it would only apply in the context of registered offerings. Except in the case of broker-dealer firms in the business of underwriting securities, in the absence of arrangements with, or compensation for selling on behalf of, the issuer, and if certain other conditions are satisfied, nonaffiliated purchasers in a registered offering have not been considered to be underwriters under current interpretations of that definition, even when they purchase a substantial portion of the registered offering or immediately resell the securities following the offering. See American Council of Life Insurance, SEC No-Action Letter, [1983 Transfer Binder] Fed. Sec. L. Rep. (CCH) 77,526 (May 10, 1983). ==========================================START OF PAGE 53====== A final benefit of this more narrow definition of underwriter would apply in the context of acquisitions. Current law deems affiliates of acquired companies to be underwriters when they resell the registered company's securities received in the acquisition.-[58]- Registered companies participating fully in the system, and thus entitled to take advantage of this narrower definition of underwriter, could make acquisitions without issuing restricted stock to the acquired company's insiders. ---------FOOTNOTES---------- -[58]- See Securities Act Rule 145(c) [17 C.F.R. 230.145(c)]. ==========================================START OF PAGE 54====== 2. Sales by Affiliates Under the current system, substantial affiliate resales (those exceeding the limits set by Rule 144) have been subjected to registration requirements, even with respect to nonrestricted securities purchased by the affiliate in registered transactions or in the open market. Again, the primary purpose of this provision was to ensure that companies do not create a public market for their shares indirectly through sales by their controlling or controlled persons when adequate information is not available concerning the issuer. As in the case of restricted securities, the need to preserve existing constraints on affiliate resales largely disappears under a company registration scheme. Since registered companies would be subject to continuous reporting obligations, and the issuer would be exposed to statutory liability for any sales made by the issuer to an affiliate, or any subsequent purchaser from the affiliate who can trace the securities back to the company registration statement, there is little concern that an affiliate may be acting as a conduit to facilitate the distribution of unregistered securities without the protections of the registration process. Similarly, resales by affiliates should not require prospectus disclosure since the sale would not affect the financial condition of the issuer. The antifraud, beneficial ownership, and Section 16 "insider" reporting and short-swing profit rules, all promulgated under the Exchange Act, apply to ==========================================START OF PAGE 55====== ensure adequate disclosure of these transactions, to the extent a sale by an affiliate impacts on the control of the issuer or the available supply of its securities in the public markets, or is indicative of possible insider trading.-[59]- The Committee proposes, therefore, that the class of persons subject to the registration requirements and resale limitations be significantly narrowed. In the case of registered companies taking full advantage of the company registration system, those persons subject to resale restrictions would include only holders of 20 percent of the voting power, or holders of 10 percent of the voting power with at least one director on the board, persons who can be presumed to be in a position to exercise control.-[60]- That presumption of a control relationship would be rebuttable.-[61]- Also ---------FOOTNOTES---------- -[59]- Milton Cohen expressed the view that delivery of a prospectus for affiliate sales was unnecessary in most instances. Cohen, supra n.2, at 1395. This concern could be further addressed under full company registration system by requiring affiliates to make prior disclosure of plans to make sales, similar to the notice provided on Form 144 today. A similar notice provision for 15% holders was proposed by the ALI Code. See Federal Securities Code 510 (Am. Law. Inst.) (Proposed Official Draft 1978). -[60]- A shareholder would not be deemed to hold a board seat merely as a result of its voting power derived pro rata as a holder of a class of securities. Rather, the right to appoint a member of the board must be derived by independent agreement or arrangement with the issuer, management or other shareholders. -[61]- While a finding of "control" will always depend upon an examination of all the facts and (continued...) ==========================================START OF PAGE 56====== included would be the CEO and inside directors, as well as the director representatives of the controlling shareholders. This class of persons subject to resale limitations is significantly narrower than that prescribed by current law, which under certain circumstances could encompass all executive officers or directors, as well as significant shareholders.-[62]- The narrower class is justified in light of the diminished concern with affiliates acting as conduits for the distribution of issuer securities.-[63]- This proposal affects solely the registration and resale requirements, not any other provisions under the federal securities laws, such as the "controlling person" liability ---------FOOTNOTES---------- -[61]-(...continued) circumstances, one significant factor in determining who controls the issuer for Securities Act registration purposes has been the ability to obtain the signatures necessary to complete the registration process. See III L. Loss & J. Seligman, Securities Regulation 1111 (3d ed. 1989); Cohen, supra n.2, at 1393. -[62]- See generally A.A. Sommer, Jr., Who's "In Control" -- the SEC, 21 Bus. Law. 559, 567-83 (1966). -[63]- The Committee recognized that contractual and other relationships also can give rise to a control relationship. However, the Committee believes that, given the inability to use conduits to avoid registration or liability under the company registration system, the narrower application of the resale restrictions is appropriate. ==========================================START OF PAGE 57====== provision under the Securities Act or the Exchange Act.-[64]- The Committee considered requiring all sales by those affiliates subject to resale restrictions under full company registration, no matter how de minimis, to be registered under the C-1 registration statement, thereby eliminating the need to apply Rule 144 to these affiliate resales as well. However, in the Committee's view, that approach would be unnecessarily broad and restrictive, since affiliates are currently permitted to sell without registration if they comply with Rule 144. Accordingly, affiliate sales meeting the applicable Rule 144 conditions need not be made under the company registration statement. The current flexibility of Rule 144 should provide those affiliates still subject to resale limitations under company registration with ample opportunity to sell securities without the necessity of obtaining the issuer's assistance in completing the registration process, as well as the payment of a fee, at the time of the resale. Issuers certainly can oversee resales by their CEO and inside directors to ensure compliance with these requirements, and avoid sales at a time when the issuer has not disclosed material developments to the market. The same is true in the case of significant shareholders who purchased from, or at ---------FOOTNOTES---------- -[64]- Section 15 of the Securities Act [15 U.S.C. 77o]; Section 20(a) of the Exchange Act [15 U.S.C. 78t(a)]. ==========================================START OF PAGE 58====== the invitation of, the issuer.-[65]- In those instances, an issuer can protect itself by obtaining a contractual agreement from the affiliate not to resell without the issuer's permission. In those cases where the affiliate's investment in the company was uninvited, the Committee considered whether special provision should be made to allow the affiliate to sell under the company registration system without the cooperation of the issuer. Unlike the case with current law, during the pilot, the affiliate of a company participating fully -- with no private placement exemption -- in the system cannot simply sell a large block of the company's securities in one or more exempt private placements, since that sale would be deemed registered for purposes of the Securities Act.-[66]- That registered sale would require an updating of the issuer's disclosure at the time of sale in order to comply with the Securities Act. The Committee did not want an issuer to be subjected to Securities Act liability for a resale transaction that it could not control. The Committee believed that it would be extremely rare that an ---------FOOTNOTES---------- -[65]- The issuer's cooperation often is required for an investor to obtain affiliate status through significant purchases of outstanding securities as a result of state takeover statutes and "poison pill" rights plans. -[66]- As discussed below, under an option to elect a modified version of the company registration system, the issuer could preserve the option to conduct exempt private placements for itself and all affiliates. See infra p. 42-45. ==========================================START OF PAGE 59====== issuer would object to an uninvited affiliate reselling into the market in a broad-based distribution. Consequently, the potential for a significant shareholder of a registered company to be locked into its investment by an uncooperative issuer seems more theoretical than real. In any event, a substantial shareholder that could not secure the assistance of the issuer in its resales may be able to demonstrate that it does not have the requisite control over the issuer, and thus rebut the presumption of control in the definition of affiliate. Absent affiliate status, the shareholder is free to resell without the registration process and the corresponding Securities Act liabilities. B. Exclusions As noted, initial public offerings would continue to be subject to a transactional registration-type regulatory process, since only companies that have conducted a registered public offering would be eligible to use the company registration system. In addition, securities not valued on the basis of the issuing company's business and financial information, such as asset-backed or special purpose issues, would not be eligible for the system. Securities that are valued in part on the basis of the issuer's performance, such as structured securities or tracking securities (e.g., GM Series H), could be made eligible subject to special disclosure requirements. Further, issuers could opt in without subjecting issuances of the types of securities currently exempt from the registration requirements of ==========================================START OF PAGE 60====== the Securities Act to the company registration system. Thus, commercial paper, tax-exempt private activity bonds and bank- guaranteed debt would remain exempt from the system. Even in the case of a company taking full advantage of the system, the Committee concluded that, during the pilot stage, placements of straight (i.e., non-convertible) debt could be excluded from the company registration system at the issuer's election; debt securities, of course, also could be included at the issuer's option. The Committee believed that straight debt placements, either on an agency basis or into the Rule 144A market, are efficient, involve mostly institutions, and therefore may not necessitate the protections provided by the registration scheme. Moreover, unlike the case with equity securities, the integration and restricted securities concepts do not appear to have created significant problems in the debt markets due to the lack of fungibility among various debt issuances. C. Offshore Offerings Under full company registration, purchasers of securities of registered companies in the U.S. trading markets would have the same disclosure and liability protections regardless of whether the securities initially were sold overseas or in this country. Offshore sales to non-U.S. persons would not have to be covered by the company registration statement. The adoption of a company registration system is not intended to result in an indirect assertion of U.S. registration jurisdiction over an issuer's offshore financing transactions. However, under full company ==========================================START OF PAGE 61====== registration, in light of the concerns regarding flowback of equity securities initially sold offshore, a participating issuer would be required to include equity securities on its company registration statement on the Form C-1 for purposes of their reentry into the United States in flowback transactions. The amount to be registered for this purpose would be based on the issuer's reasonable estimate of the likely flowback into the United States. Thus, U.S. purchasers of equity securities initially offered overseas would benefit from whatever statutory protections are afforded to secondary market purchasers by Section 11 of the Securities Act for the period of the applicable statute of limitations, running from the time of the initial sale by the issuer. As a result, the concerns that have arisen with respect to Regulation S offerings of equity securities with an established trading market in this country-[67]- would evaporate as a practical matter in the context of sales by registered companies, because U.S. purchasers would be protected to the same extent as if the securities initially had been issued in the United States. D. Preservation of Transactional Exemptions The Committee engaged in considerable discussion on whether companies participating in the company registration system should be able to rely on exemptions for private placements and other ---------FOOTNOTES---------- -[67]- Problematic Practices Under Regulation S, Securities Act Rel. 7190 (June 27, 1995) [60 FR 35663 (July 10, 1995)]. ==========================================START OF PAGE 62====== transactions that are available today from the registration and liability provisions of the Securities Act. On the one hand, the inclusive nature of company registration ensures that issuers could not use conduits to avoid liability that results from the registration of securities. Treating all sales as registered generally eliminates the need for such concepts as restricted securities, integration, general solicitation and flowback of unregistered securities issued abroad, with respect to securities issued by companies opting into the system. To the extent company-registered issuers or affiliates are permitted to engage in unregistered private placements, the need for resale restrictions and other concepts that burden the current scheme would remain, thereby costing the new system some of its expected benefits. On the other hand, the loss of the private placement option, and thus the potential for increased liability and possible disclosure concerns arising from the need to update the company's public disclosures and file the transactional information, as well the need to pay a registration fee, when making a company-registered offering could be a deterrent to the use of the company registration system.-[68]- ---------FOOTNOTES---------- -[68]- Transcript of May 8, 1995 Advisory Committee Meeting at 177 (statements of Professor Coffee). The same concern may arise with respect to the ability to conduct an offshore offering under Regulation S without having to register the securities offered for flowback purposes or otherwise. If the issuer is contemplating an acquisition, Regulation S offers a means for the issuer to avoid delaying the offer until the full acquisition disclosure is available. The (continued...) ==========================================START OF PAGE 63====== Therefore, to permit a fair test of the company registration concepts during the pilot stage, the Committee believed that issuers should be afforded the option of continuing to conduct private placements, while still taking advantage of most of the benefits of the system. Companies could choose either to waive transactional exemptions, such as those for small issuances (3(b) and Regulation A), private offerings (4(2)) and Regulation D (Rules 504, 505 and 506)), intrastate offerings (3(a)(11) and Rule 147), issuer exchange offers (3(a)(9)), and transactions pursuant to fairness hearings (3(a)(10)), as well as the jurisdictional safe harbor of Regulation S, or determine to preserve the option to exclude those transactions from the company registration system under a modified or less comprehensive version of this system. In the case of participation in full company registration, other than the limited exclusions for exempt securities discussed above (commercial paper, bank debt, etc.), all issuer and affiliate sales (outside Rule 144) would be deemed "registered" for Securities Act purposes. Thus, regardless of the nature of ---------FOOTNOTES---------- -[68]-(...continued) Commission has proposed to address that concern by conforming the acquisition disclosure and accounting requirements under the Securities Act to the same standard as under the Exchange Act. See Streamlining Disclosure Requirements Relating to Significant Business Acquisitions and Requiring Quarterly Reporting of Unregistered Equity Sales, Securities Act Rel. 7189 (June 27, 1995) [60 FR 35656 (July 10, 1995)] (the "Streamlining Business Acquisitions Release"). ==========================================START OF PAGE 64====== the transaction in which the securities were originally issued, the securities would be freely tradeable. Purchasers of those securities from the issuer or an affiliate (outside Rule 144) would enjoy the same remedies and disclosure protections as would be the case if they purchased securities issued today in a registered public offering. Companies participating in the modified version of the system still would benefit from the "file and go" registration process, so long as they agree to the disclosure enhancements. Securities issued in excluded transactions, however, would be restricted securities subject to current holding periods and resale limitations to the same extent they are today.-[69]- The new, more limited, applicability of resale limitations to affiliates and definitions of underwriter would not apply with respect to those issuers and transactions.-[70]- These ---------FOOTNOTES---------- -[69]- Although certain of the forms of exempt transactions do not result in the issuance of restricted securities under current law, they are subject to limitations and restrictions that condition the exemption, as well as potential integration, that would not apply if conducted on a registered basis. -[70]- The company registration model envisioned by the ALI Code also provided for exempt limited offerings. Those offerings were defined as sales up to 35 buyers as well as an unlimited number of institutional investors. See Federal Securities Code Section 242(b) (Proposed Official Draft 1978) (Am. Law Inst.). While strict resale limitations were not imposed, securities issued in those transactions could not be held by more than 35 noninstitutional investors for one year after the issuance in the case of seasoned issuers. Id. ==========================================START OF PAGE 65====== exempt offerings, however, would not be subject to integration with registered offerings conducted on the Form C-1. This dual approach, while adding complexity to the company registration system during the pilot stage, would permit issuers and their purchasers to weigh the costs and benefits of full registration of all transactions versus private placements. In the Committee's view, even during the pilot stage, the benefits resulting from registration, including the issuance of freely tradeable securities in what otherwise would have been a private transaction resulting in restricted securities, should outweigh any additional costs imposed by registering the securities under the system. In addition, given the extensive representations and warranties that normally are provided to purchasers in a private placement, the fact that company- registered transactions would be subject to Securities Act statutory liability should not be a significant deterrent. Similarly, the discount that normally adheres to private placements (as high as 20 percent for equity securities) should far outweigh the registration fee paid in registered offerings (.034 percent). E. Limited Placements An issuer participating in the full company registration system may be concerned that it will not be able to raise capital at a time when it is not in a position to disclose information currently required in a registered offering. This situation may arise due to a material business development that must remain ==========================================START OF PAGE 66====== nonpublic for legitimate business reasons, the need to update financial statements that have "gone stale," its offering documentation (for example, the Form 8-K filing) not being completed in time to take advantage of a market opportunity, or a company's auditor not consenting to the use of its report in connection with a registered offering. All of these reasons may induce a company to continue to conduct private placements. In these cases, an issuer could conduct a limited placement of securities to one or more accredited investors, so long as those securities (and any price-related securities) are not traded by the purchaser until full disclosure is provided to the public through a Form 8-K or other public filing of such information and its inclusion in the Form C-1. Of course, the issuer still would have to make full disclosure to the purchaser at the time of the sale (which could be done in writing as well as orally), subject to whatever confidentiality agreements with the purchaser that the issuer deems necessary. In this manner, once the disclosure is made to the public, the purchaser would have freely tradeable securities. The duration of any restriction on resale would be determined by the parties, not a fixed holding period set by Commission rule. In addition, unlike an exempt offering, the liability provisions of the Securities Act would attach to the securities originally issued in these limited offerings. ==========================================START OF PAGE 67====== IV. Disclosure Enhancements Under the Recommended Company Registration Model Adoption of a company registration system creates the opportunity for raising the quality and integrity of disclosure provided routinely to the markets through the company's Exchange Act reports in a variety of ways: (a) by requiring a heightened focus on the part of senior managers and directors on their existing financial reporting responsibilities; (b) by increasing the scope and currency of disclosure to the markets of specified material developments; and (c) by increasing the opportunity for outside gatekeepers or monitors to participate. Because company registration relies on the integrity of publicly available information and an efficient market for an issuer's securities, adherence to the recommended enhancements would be a condition to continued participation in the company registration system. As a result, investors in the secondary trading markets, as well as those participating in primary offerings, would benefit from more comprehensive, current and reliable information. As envisioned by the Committee, company registration relies heavily on the public availability of accurate and complete information relating to a registered company's business and financial condition. Viewed in this light, the Committee's model of company registration represents a logical extension of the Commission's integrated disclosure scheme. Despite integration and a gradual shift in emphasis of Commission staff review over the past decade away from Securities Act transactional documents and toward Exchange Act periodic reports, there remain substantial differences in the quality of the disclosures provided under each statute.-[71]- The expense of ---------FOOTNOTES---------- -[71]- As such, not much has changed since Milton Cohen observed in 1985: (continued...) ==========================================START OF PAGE 68====== continuous due diligence of the caliber expected in a primary distribution, coupled with issuers' legitimate need to control the timing of public disclosure of material developments, make it difficult for Exchange Act documents always to achieve true parity in terms of reliability and currency with documents filed in connection with registered offerings.-[72]- However, ---------FOOTNOTES---------- -[71]-(...continued) Disclosure for [Exchange] Act purposes still tend to be taken far less seriously, and to be of lower quality, than those historically provided, and still aspired to, under the [Securities] Act. . . . Because of this disparity, and the disparity in liability provisions that it reflects, the SEC has considered it necessary for a registrant, on the occasion of a public offering, not merely to supplement its latest [Exchange] Act disclosures but to bring them within the coverage of section 11 by, at least, incorporating them by reference into a [Securities] Act registration statement. Cohen, Unfinished Business, supra n.37, at 992. See 1977 Advisory Committee Report, supra n.4, at 425-26. -[72]- Traditionally, there have been "[t]wo principal qualitative reasons for placing particular stress" on Securities Act filings by comparison with Exchange Act filings, as suggested by the Wheat Report in 1968: First, the buyer of securities in an initial distribution is in a somewhat different position from the buyer in the trading markets. Not only the [Securities] Act but much of the legislation previously passed by the states in the securities field rests on this premise. The compensation that dealers and salesmen receive when they participate in a [Securities] Act offering is almost always appreciably more generous than that customarily received in exchange or over-the-counter trading. New securities have to be distributed in short order. Special efforts (continued...) ==========================================START OF PAGE 69====== the Committee believes that additional improvements in Exchange Act disclosures -- especially with respect to the attention paid by senior management, outside directors and other gatekeepers or monitors -- would achieve more fully the intent of the Commission when it integrated the disclosure requirements of the two statutes in 1982. Accordingly, the Committee recommends that the Commission implement a series of mandatory disclosure enhancements applicable to registered companies. Voluntary, but encouraged, measures such as SAS No. 71 reviews and appointment of a disclosure committee, should operate in tandem with the mandated ---------FOOTNOTES---------- -[72]-(...continued) are necessary if disclosure is to serve as a useful shield against the dangers inherent in such a situation. Second, new public offerings, especially those for the accounts of issuers, have a special economic significance. The transaction in which one investor purchases from another a security originally issued many years ago has less impact on the economy than one in which the investor's dollars go directly into the treasury of a corporation in order to help it to develop a mine, construct a new plant, or exploit a new technological development. A special disclosure effort may well be justified when allocation of capital in a free society is affected. . . . . . . For these reasons, among others, quantitative differences between the new issue and trading markets must be regarded with caution. Nevertheless, in the Study's judgment, the statistics demonstrate the need to achieve a better balance in disclosure policy, with greater emphasis on continuing disclosures for the trading markets. Wheat Report, supra n.3, at 60-61. ==========================================START OF PAGE 70====== enhancements to facilitate greater outside director, auditor, and underwriter attention to existing Securities Act due diligence responsibilities. Both the mandatory and voluntary measures recommended by the Committee, therefore, should improve the quality and integrity of corporate disclosure in connection with not only primary distributions, but also the Exchange Act reports upon which the trading markets depend. A. Mandatory Disclosure Enhancements Committee member Robert Elliott has urged the Committee to expand its primary focus on the reliability of the corporate reporting process to address perceived problems in the content of the resultant disclosures. Mr. Elliott raised the concern, echoed in the Jenkins Committee Report,-[73]- that much SEC-prescribed financial reporting may have become obsolete, redundant of generally accepted accounting principles ("GAAP") or otherwise of marginal utility to the investing public.-[74]- These financial reporting issues are ---------FOOTNOTES---------- -[73]- See supra n.39. Mr. Elliott was a member of the Jenkins Committee. -[74]- In a letter dated November 10, 1995 from Mr. Elliott to Committee Chairman Wallman, Mr. Elliott suggested that the Commission conduct research into investor informational demands that focuses on "[t]he trade-off between relevance and reliability," noting that Jenkins Committee data show that investors "would prefer more relevance, even at the cost of reliability." See Documents for Advisory Committee Meeting, November 21, 1995, Tab E (Letter dated November 10, 1995 from Robert Elliott to Commissioner Wallman at 2). As Mr. Elliott points out: (continued...) ==========================================START OF PAGE 71====== relevant to the Commission's administration of its disclosure program regardless of whether the Commission determines to move to a company registration system. In addition, the recommendations of the Jenkins Committee already were being considered by representatives of the affected constituencies prior to the establishment of the Advisory Committee.-[75]- For these reasons, the Committee determined to defer to these other ongoing evaluations of the need to reform financial ---------FOOTNOTES---------- -[74]-(...continued) If registrants are willing to pay some measure of cost to become C-1 companies, they should be just as willing to devote that measure to the incremental relevance it would purchase as to the incremental reliability it would purchase. This is a policy choice that the SEC can and should make for the sake of its investor- protection mission. . . . Companies often misperceive costs because they fail to count the capital-cost reduction benefit from clear, honest, complete disclosure policies. The SEC should undertake to study these benefits through independent economic analysis and make the case to registrants that disclosures helpful to investors' decision making provide capital-cost reductions (as long as they don't reveal matters to competitors that (a) are economically deleterious and (b) the competitors didn't already know). Id. at 2-3. -[75]- The Committee was advised by the analyst community that it would be premature to take up the Jenkins Committee Report recommendations before they are thoroughly examined by the accounting, corporate and end-user communities, as well as the FASB. See Documents for Advisory Committee Meeting, September 29, 1995, Tab E (Letter dated September 27, 1995 from the AIMR to Commissioner Wallman, at 6). ==========================================START OF PAGE 72====== reporting and confine its recommendations in this area to the substantial enhancement of reporting procedures and the reliability of reported information. The Committee did make substantive reporting proposals, however, such as the proposed changes to the existing Forms 10-K and 8-K disclosures, where it believed they were necessary.-[76]- 1. Enhanced Involvement by Senior Management When the Commission mandated in 1980 that senior managers and at least a majority of the board of directors sign a registrant's annual report on Form 10-K,-[77]- the Commission expected management and the board to focus their attention on the disclosures in the annual report. In practice, ---------FOOTNOTES---------- -[76]- The Committee also considered, but rejected as unnecessarily burdensome when balanced against likely investor benefits, a requirement that registered companies report in a timely manner all material developments similar to the obligation issuers now incur as a condition to listing on the New York Stock Exchange. See NYSE Listed Company Manual 202.05 (listed companies expected to "release quickly to the public any news or information which might reasonably be expected to materially affect the market for its securities"); see also American Stock Exchange Company Guide 1102, and National Association of Securities Dealers By-laws, Schedule D. For substantially the same reason, the Committee did not require registered companies to procure auditor attestation of their management discussion and analysis, or obtain an opinion of counsel on periodic reports. -[77]- See General Instruction D to Form 10-K, adopted in Amendments to Annual Report Form, Related Forms, Rules, Regulations,and Guides: Integration of Securities Acts Disclosure Systems, Securities Act Rel. 6231 (Sept. 2, 1980) [45 FR 63630 (September 25, 1980)] (the "Annual Report Release"). ==========================================START OF PAGE 73====== however, some of these corporate officials still devote far less attention and care to the preparation and review of the Form 10-K and other periodic and current Exchange Act reports than are generally seen in the Securities Act context. When presenting and discussing this issue, both the Committee and its staff repeatedly were advised that a routine practice among some reporting companies is merely to have senior management (and directors for the Form 10-K) execute the signature pages of a required Exchange Act report without receiving, and hence reviewing, the remainder of the document.-[78]- Whatever the causes of the disparities between the level of attention given to the preparation of Securities Act and Exchange Act disclosure documents, the result is clear -- the senior management of many registrants could do far more than they are doing today to assure the quality and reliability of information disseminated to the nation's public trading markets. Two measures recommended by the Committee are intended to heighten top managers' compliance with present reporting responsibilities: (i) the certification by top management to the Commission that specified Exchange Act disclosure documents have been reviewed by them and do not, to the reviewing manager's knowledge, contain any materially false or misleading information, and (ii) a senior management report addressed and submitted to the audit committee of the board of directors (or its equivalent) describing ---------FOOTNOTES---------- -[78]- See pp. 46 and 51 of Appendix A to the Report. ==========================================START OF PAGE 74====== procedures adopted both to ensure the integrity and accuracy of such disclosure documents, and to prevent insider trading. a. Top Management Certifications In requiring certification by responsible senior managers that each Exchange Act report has been read, and that the particular manager is not aware of any material misstatement or omission in that report, the Committee hopes that the Commission's longstanding objective of encouraging management (as well as directors, accountants and attorneys) to refocus its attention on the sufficiency of Exchange Act filings in order to instill "a sufficient degree of discipline ... in the [integrated disclosure] system to make it work" might be fulfilled.-[79]- Rather than create additional ---------FOOTNOTES---------- -[79]- Annual Report Release, supra n.77 (discussing reasons for imposing obligation to sign the Form 10-K upon the issuer's principal executive officer, certain additional officers, and a majority of the board of directors). Compare 1977 Advisory Committee Report, supra n.4, at 426-27 (rejecting a suggested requirement that a majority of the issuer's board of directors sign each Exchange Act report that would be incorporated by reference into a short-form registration statement, based on commenters' concerns that the increased liability the director signatories thus might incur would deter use of the short form; however, the Committee "encourage[d] the Commission to consider this concept as a possible means of upgrading the quality of reporting by improved attention by directors and top officers to their filings and the consequent enhanced possibility of liability"). Without addressing directly the 1977 Advisory Committee's conclusion, the Commission in expanding the Form 10-K signature requirement to require a majority of the board to execute this document regardless of its potential incorporation by reference into a (continued...) ==========================================START OF PAGE 75====== managerial duties or liabilities, the new certification requirement is intended to prompt the dissemination of more reliable and informative disclosures to the markets for registered companies' securities. An affirmative attestation obligation may well succeed in accomplishing what signature requirements alone apparently have not -- underscoring top management's duty to monitor the accuracy and integrity of all information contained in its corporate reports. The Committee recommends that a minimum of two of four designated senior executive officers (or their functional equivalents) in a position to influence the content and quality of a registered company's disclosures -- the Chief Executive Officer, the Chief Operating Officer, Chief Financial Officer, or Chief Accounting Officer -- provide this attestation to the Commission in connection with the filing of each Form 10-K, Form 10-Q, and mandatory Form 8-K.-[80]- In the Committee's view, these ---------FOOTNOTES---------- -[79]-(...continued) Securities Act form, reasoned that "this added measure of discipline is vital to the disclosure objectives of the federal securities laws, and outweighs the potential impact, if any, of the signature on legal liability." Annual Report Release, supra n.77 [45 FR at 63630]. -[80]- A Form 8-K must be filed in connection with any one of the following per se material events: (a) change in control of the registrant (Item 1); (b) acquisition or disposition of a significant amount of assets outside the ordinary course of business (Item 2); (c) bankruptcy or receivership (Item 3); (d) changes in registrant's certifying accountants (Item 4); and (e) resignations of directors (Item 6). The five additional mandatory 8-K line items that the Committee recommends the Commission (continued...) ==========================================START OF PAGE 76====== four senior officials (or their functional equivalents) are in the best position to ensure that the company's disclosures fully and fairly describe the company's financial condition, results of operations and prospects. b. Management Report to the Audit Committee Complementing the requirement of senior management attestation, the Committee also recommends the adoption of a management report addressed to the audit committee of the board of directors on mechanisms established to assure accurate and complete Exchange Act reporting. Specifically, the management of registered companies should be required to prepare and submit to the board's audit committee (or a functionally equivalent committee, including the disclosure committee if appointed and different from the audit committee, or in the absence of either, the entire board) a report describing the company's practices and procedures, if any, to assure the integrity of all periodic and current reports filed under the Exchange Act. This report should also contain a description of any procedures adopted by the company to deter and/or detect insider trading abuse.-[81]- ---------FOOTNOTES---------- -[80]-(...continued) adopt, discussed infra at p. 55-56, also would trigger the proposed attestation obligation. However, no such obligation would result from the voluntary filing of a Form 8-K pursuant to Item 5 thereof. -[81]- For example, many public companies require all executive officers to obtain prior approval of any purchase or sale of company securities. The Committee included this provision because of the belief that appropriate mechanisms to deter (continued...) ==========================================START OF PAGE 77====== The Committee suggests that the Commission require the new report to be filed as an exhibit to the registered company's Form 10-K. Absent a material change in its content, the report would not need to be refiled on an annual basis. While the Committee is not recommending that the Commission compel the adoption of any specific set of procedures, public disclosure of actual procedures used by registered companies to ensure the integrity and quality of their Exchange Act filings should lead to the development of a private sector set of "best disclosure practices." Members of the board, investors and management of registered companies likely will explore whether procedures followed by competitors and comparable issuers might function to improve the quality of their own reports. The scope of the required "procedures" disclosure should include a detailed description of the steps currently taken by the company to prepare its required reports so that investors and others can gauge the quality of the preparation procedures. This report would not require an assessment of the overall adequacy of a registered company's broader system of internal controls designed to protect and preserve the integrity of ---------FOOTNOTES---------- -[81]-(...continued) insider trading will increase the expected level of integrity of the company's public reports, and because the reduction in resale limitations on some insiders could warrant better controls and monitoring within a company on insider transactions. ==========================================START OF PAGE 78====== financial reporting, compliance with GAAP, and operations.-[82]- Thus, the recommendation is far narrower than prior Commission rulemaking proposals calling for management reports on internal controls.-[83]- The Committee does not ---------FOOTNOTES---------- -[82]- See ABA Committee on Law and Accounting, "Management" Reports on Internal Control: A Legal Perspective, 49 Bus. Law. 889, 920 (1994) (the "ABA Report") (observing that "it appears that the SEC and the COSO [Committee of the Sponsoring Organizations of the Treadway Commission, a private-sector group of accounting experts formed in 1985 to study the U.S. financial reporting system] believe that controls cannot be immutably characterized as exclusively related to just one category of objectives -- of operations, or financial reporting, or compliance -- and for this reason, they no longer will use the term internal accounting control"). -[83]- See Report of Management's Responsibilities, Securities Act Rel. 6789 (July 19, 1988) [53 FR 28009 (July 26,1988)] (proposing a management report to the board of directors or its audit committee -- to be published in the company's Form 10-K and annual report to shareholders -- to describe management's responsibilities for the preparation of the company's financial statements and other related information and for establishing and maintaining a system of internal controls for financial reporting.) Almost a decade earlier, the Commission had proposed to require inclusion in each Form 10-K and annual report to securityholders (filed under the proxy/information statement rules) of a statement of management's opinion as to whether the registrant's system of internal accounting controls offered reasonable assurance that only appropriately authorized transactions were executed consistent with the books and records provisions of the Foreign Corrupt Practices Act of 1977 (now codified in Section 13(b)(2) of the Exchange Act [15 U.S.C. 78(m)(b)(2)]), and that transactions were recorded as necessary to permit preparation of financial statements in accordance with GAAP and to maintain accountability for assets. See Statement of Management on Internal Accounting (continued...) ==========================================START OF PAGE 79====== believe it is necessary, and therefore recommends that the Commission not require, senior management of registered companies to provide a public evaluation of internal controls. Similarly, the Committee does not support a requirement that the report represent that prescribed procedures were followed with respect to the preparation of any particular filing. Indeed, an adequate description of procedures could recognize expressly management discretion to depart from the standards under appropriate circumstances.-[84]- ---------FOOTNOTES---------- -[83]-(...continued) Control, Exchange Act Rel. 15772 (April 30, 1979) [44 FR 26702 (May 4, 1979)]. This proposal was withdrawn one year later. Statement of Management on Internal Accounting Control, Exchange Act Rel. 16877 (June 6, 1980) [45 FR 40134 (June 13, 1980)]. -[84]- Some have raised concerns that public disclosure of the report would expose the certifying officials to a greater risk of private litigation or a Commission enforcement action. The fact that a report detailing procedures for preparation of a document is publicly filed would not enhance a company's potential liability in a suit premised upon materially false or misleading disclosures made in Commission documents. Even if viewed as an implicit representation to the market that the disclosed procedures were followed, it would be difficult for a plaintiff to argue that noncompliance with these procedures added to the damages suffered by investors. Any such suit would be premised on a misrepresented material fact or material omission regarding the issuer or its securities, not the lack of devotion to a particular procedure. Though potentially relevant to whether the defendant met the requisite standard of care or mental state, a company's procedures and management's compliance therewith likely would be discoverable whether or not those procedures are contained in a filed report. The issuer could be liable, however, in a Commission (continued...) ==========================================START OF PAGE 80====== 2. Improvements in the Content and Timeliness of 1934 Act Reporting The Committee also recommends that the Commission effect certain enhancements to the content and timeliness of corporate disclosures provided to the markets by companies participating in the company registration system. These enhancements increase the currency of disclosure of material developments relating to a registered company, and add key information on investment risk to the annual report on Form 10-K. a. More Timely and Informative Reports on Form 8- K The Committee recommends that expansion of the current Form 8-K reporting obligation to mandate or accelerate disclosure of the following five additional material developments. Of these, two would entail no more than earlier reporting of information already prescribed by Form 10-Q (Nos. 1 and 3, below). The remaining three requirements would, in many instances, already be required to be disclosed promptly either due to general liability concerns under antifraud provisions-[85]- or listing requirements.-[86]- 1. Material modifications to rights of holders of registered company securities, whether favorable or unfavorable, now reportable only on a quarterly basis ---------FOOTNOTES---------- -[84]-(...continued) action for a materially false or misleading filing if the reports were, for example, fraudulent. -[85]- See Basic Inc. v. Levinson, 485 U.S. 224 (1988). -[86]- See, e.g., NYSE Listed Company Manual 2. ==========================================START OF PAGE 81====== in Form 10-Q.-[87]- A common criticism of quarterly reports today is that this and other key information is stale by the time it reaches the broader investing public, whereas more sophisticated institutional investors and analysts obtain timely access to such information directly from senior management. The Committee believes that more prompt disclosure of important changes in securityholder rights, such as the imposition of restrictions on (or cessation of) dividend payments or the elimination of preemptive rights, both of which currently need not be reported until 45 days after the end of the quarter in which they occur, should level any perceived informational imbalance among investors and improve market efficiency. 2. Resignation or removal of any of a registered company's five most senior executive officers, currently required in the Form 8-K exclusively for directors. Because general principles of materiality and listing standards in any event often result in prompt disclosure of the termination of the CEO and other members of top management,-[88]- the creation of a bright line test prescribing the timing of and vehicle for such disclosure should not impose appreciably greater compliance burdens on registered companies when measured against the obvious investor and market informational benefits. 3. Specified material defaults upon senior securities, which today must be disclosed solely in Form 10- Q.-[89]- For the same reasons outlined above, the Committee recommends that the Commission accelerate disclosure of this information. 4. Sales of a significant percentage of the company's outstanding equity, whether in the form of common shares or convertible securities, or made on a registered or exempt basis. In proposing to require quarterly disclosure of unregistered equity sales during the covered period, whether pursuant to a ---------FOOTNOTES---------- -[87]- See Item 2 of Form 10-Q. -[88]- See NYSE Listed Company Manual  204.15 ("[p]rompt notice is required to be given to the exchange of any changes in directors or officers of the company"). -[89]- See Item 3 to Form 10-Q. ==========================================START OF PAGE 82====== private placement, a Regulation S offering or otherwise, the Commission already has recognized the importance of this information to the markets.-[90]- Comment was sought in the relevant proposing release on whether this information will be disclosed in a sufficiently timely manner if required on Form 10-Q, or instead should be reported on a mandatory Form 8-K or notice of sale similar to that used for Regulation D offerings. The Committee believes that such information is material to investors and should be disseminated to the markets on a more timely basis than in a quarterly report. 5. The issuer's receipt of notice from its independent auditor that reliance on an audit report included in previous filings is no longer permissible because of the auditor's concerns with respect to the continuing viability of the company as a going concern or a variety of other matters. Also reportable would be an issuer's effort to engage another auditor to reaudit a period covered by a prior filed audited report, whether due to the predecessor auditor's withdrawal of its consent or any other reason. Timely disclosure of this information will serve to reinforce the auditor's role as a gatekeeper or monitor on a continuous basis, a principal goal of company registration. b. Form 10-K Risk Disclosure An analysis of risks associated with investment in a company's securities is now required in all Securities Act filings, to the extent material.-[91]- No such requirement currently applies in the context of Exchange Act reporting. As a result, investors in the trading markets do not have access to the company's own evaluation of the mix of material factors ---------FOOTNOTES---------- -[90]- See Streamlining Business Acquisitions Release, supra n.68. -[91]- See Regulation S-K, Item 503 [17 C.F.R. 229.503]; see also Regulation S-K, Item 506 [17 C.F.R. 229.506] (dilution of existing holders), referenced in Forms S-1, S-2, S-3, and S-4, among other forms. ==========================================START OF PAGE 83====== bearing on investment risk except when the company elects to raise capital through a public offering of securities. This information traditionally has been viewed as extremely useful for both potential and existing investors.-[92]- The Committee believes that participating companies, investors, and the markets, would benefit from the inclusion of risk disclosure requirements in the annual report on Form 10-K, for those companies that currently would be required to provide such information in a Securities Act filing. The Committee recognizes that for many of the companies initially subject to the pilot, no such disclosure is currently required and none would be required in the Exchange Act reports. However, where a discussion of material risk factors would be required when the company is selling its own securities, it also should be required when investors are purchasing the securities in the secondary trading markets. Provided that the mandatory risk disclosures are not obscured or rendered materially false or misleading, the company could (and, in fact, should be encouraged to) amplify such disclosure with a discussion of the benefits of ownership of a particular class of securities. Registered companies would gain the advantage of being able to incorporate the risk factor analysis by reference from the Form 10-K to satisfy line item requirements in other documents prescribed by ---------FOOTNOTES---------- -[92]- See, e.g., Jenkins Committee Report, supra n.39, at 29. See also 1977 Advisory Committee Report, supra n.4, at 486-487. ==========================================START OF PAGE 84====== Commission rule under the Securities Act and the Exchange Act.-[93]- In addition, any material change in the risk disclosure should be provided in the next Form 10-Q. ---------FOOTNOTES---------- -[93]- Obviously, companies could not rely on general disclosures in the Form 10-K to describe the unique risks of investing in certain classes of complex or novel securities. Those unique risks would have to be separately described, as today. ==========================================START OF PAGE 85====== B. Conclusion The Committee anticipates that the mandatory disclosure enhancements should improve the quality of information provided by registered companies in connection not only with episodic securities distributions, but also disclosures made on a continuous basis through periodic and current reports filed under the Exchange Act. Some members of the Committee have indicated that they would not limit the recommendation to companies participating in the company registration system since, in either offerings under the shelf or recommended company registration system, issuers can access the markets quickly without intervention by the Commission staff. The current universal shelf has raised the same concerns regarding adequate opportunity for due diligence that also have been raised with respect to company registration. For these reasons, some members urged that the disclosure enhancements be made a condition to the use of the shelf for equity offerings over a specified amount. Put simply, the price for this speedy, unfettered access to the markets in the case of substantial equity offerings, whether under a shelf or the company registration system, should be the enhancements designed to improve the level and reliability of corporate reports and facilitate the gatekeeping function. If required to comply with the disclosure enhancements and investor protections (such as Form 8-K filing for non-de minimis equity offerings) in order to conduct a shelf offering, there would be little reason for current shelf issuers not to opt into ==========================================START OF PAGE 86====== the company registration system, at least the modified version, in order to benefit from the added flexibility of the company registration system. Taken together, while imposing requirements to enhance the level of disclosure and investor protection, the resulting system would represent a significant expansion and liberalization of the shelf procedure. On balance, the Committee concluded that modification of the existing shelf registration to impose all the disclosure enhancements is not necessary just to implement company registration, at least on a pilot basis. At the same time, the Committee recommends that a Form 8-K be required for non-de minimis equity offerings conducted on the current shelf, and that the Commission give careful consideration to whether requiring disclosure enhancements across the board for shelf registrants as well, could lead to measurable improvements in the current disclosure. V. Liability and Due Diligence Under Company Registration Company registration will preserve the current statutory liability provisions and, indeed, will extend those protections to transactions that today are conducted without registration, such as private placements and offshore offerings. Company registration also will promote more effective and continuous due diligence. Directors, underwriters and other parties with due diligence obligations will receive more useful guidance on their ability to consider, in meeting those obligations, the ongoing oversight of the company's disclosures conducted by persons who are better positioned to perform that role. A. Liability Under Company Registration 1. Other Liability Approaches Considered ==========================================START OF PAGE 87====== The Committee considered several liability schemes that could be applied under a company registration system with the goal of preserving and enhancing the gatekeepers' or monitors' existing roles in protecting investors. In recommending the proposed company registration model and pilot project, the Committee concluded that retention of the current liability scheme, at least during the pilot stage, would maintain important investor protections while achieving the objectives of company registration, provided that additional guidance was furnished to gatekeepers on the factors relevant to establishing a due diligence defense under Sections 11 and 12(a)(2) of the Securities Act. Section 11 creates strict liability for the benefit of any purchaser of a security sold pursuant to a materially false or misleading registration statement on offering participants (including the issuer, officers and directors, underwriters and experts, such as the accountants), but provides the defendants other than the issuer with a defense based essentially upon proof that they engaged in a reasonable investigation and had reasonable grounds to believe in the accuracy of the disclosure.-[94]- Section 12(a)(2) allows purchasers to ---------FOOTNOTES---------- -[94]- Under Section 11 of the Securities Act, a lower standard of due diligence must be met as to "expertized" portions of the registration statement by persons other than the certifying expert. The defendant invoking this affirmative defense must show that, "he had no reasonable ground to believe and did not believe, at the time such part of the registration statement became (continued...) ==========================================START OF PAGE 88====== recover against their sellers (a much more narrow class than that covered by Section 11), unless the sellers can show that they were not negligent in failing to discover false and misleading statements. Remedies available pursuant to Section 12(a)(1) of the Securities Act for Section 5 violations, as well as Sections 10 and 18 of the Exchange Act, and Rule 10b-5 adopted thereunder for fraud, also would continue to be available in the same manner as today under the shelf registration system. During the July 26, 1995 Advisory Committee Meeting, the Committee analyzed, in addition to maintaining the current liability scheme, the following alternatives: (i) a liability structure in which issuers would incur Section 11 liability only for IPOs and extraordinary distributions, and Section 12(a)(2) liability for routine transactions. Under this approach, Section 12(a)(2) would apply to all prospectus disclosure, including information incorporated by reference; (ii) extending Sections 11 and 12(a)(2) remedies to all purchasers in primary offerings and in secondary market transactions contemporaneous with the offering. The company's total liability would have been limited to the lesser of the dollar amount of the offering proceeds or damages caused. Awarded damages then would be prorated among investors in the primary and secondary markets; (iii) eliminating Section 11 liability and extending Section 12(a)(2) liability to all statements by the issuer (including those currently subject only to Rule ---------FOOTNOTES---------- -[94]-(...continued) effective, that the statements therein were untrue or that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading." Section 11(b)(3)(C) of the Securities Act [15 U.S.C. 77k(b)(3)(C)]. ==========================================START OF PAGE 89====== 10b-5) regardless of whether the issuer is selling securities or its securities are trading in the secondary market;-[95]- and (iv) limiting liability for a registered company's routine financings to Rule 10b-5 liability only.-[96]- In this regard, the Committee considered differing views on the impact of Sections 11 and 12(a)(2). In its analysis, the Committee found it difficult to determine the full extent of Section 11 litigation and the effects of Section 11 liability exposure on issuers' financing choices. According to several commenters, there are few reported cases actually decided on Section 11 grounds,-[97]- but in meetings with industry representatives the Committee staff was informed that a significant number of potential Section 11 claims are settled without actions being instituted or without reported decisions.-[98]- ---------FOOTNOTES---------- -[95]- For a discussion of a somewhat similar liability scheme in which a negligence standard like Section 12(a)(2) would be extended to Exchange Act documents, and consequently a civil remedy would be available for purchasers of a company's securities in the open market as well as in capital raisings, see Margaret Bancroft, Responding to Gustafson: Company Registration and a New Negligence Standard, INSIGHTS, July 1995, at 14. -[96]- See Documents for Advisory Committee Meeting, July 26, 1995, Tab C. -[97]- Transcript of July 26, 1995 Advisory Committee Meeting at 287 (statements of Commissioner Wallman and Professor Coffee). -[98]- Some have suggested, however, that Section 11(e)'s requirement of an undertaking for the payment of (continued...) ==========================================START OF PAGE 90====== Notwithstanding the absence of dispositive evidence of the effect of Section 11 on disclosure practices and an issuer's choice of whether to engage in a public or private offering, it is the Committee's view that Section 11 liability continues to play an integral role in compelling "truth in securities." Congress explicitly recognized the importance of the role of underwriters and other monitors in the offering process by including them in the group of persons potentially liable for omissions or misstatements in registration statements. As Milton Cohen stated, the liability provisions have "had the in terrorem effect of creating an extraordinarily high sense of care and responsibility in the preparation of registration statements."-[99]- Consequently, the Committee believed that Section 11 should continue to be applied under a company registration system in a manner similar to its current application.-[100]- ---------FOOTNOTES---------- -[98]-(...continued) litigation costs if the court determines the suit or defense to be without merit and the difficulty faced by purchasers in the open market of tracing the securities back to the registration statement in question act as an impediment to Section 11 suits. See Edward F. Greene, Determining the Responsibilities of Underwriters Distributing Securities Within an Integrated Disclosure System, 56 Notre Dame L. Rev. 755, 770 n.90 (1981). -[99]- Cohen, supra n.2, at 1355. -[100]- It also has been suggested that the Committee should urge the Commission to express disagreement with the well-established policy against indemnification of underwriters for Section 11 liability, at least in the context of shelf and (continued...) ==========================================START OF PAGE 91====== 2. Preservation and Expansion of Statutory Liability During the pilot stage, purchasers in offerings by registered companies would have recourse pursuant to Section 11 to the same extent as under the current liability system. Issuers, officers, directors, experts, and underwriters would be subject to Section 11 liability for false or misleading statements in the Form C-1, including all incorporated information filed in Exchange Act reports. Indeed, for those issuers that elect to take full advantage of the system and register all of their securities issuances, the Section 11 remedy would be available to purchasers in private placement transactions that otherwise would be exempt under the current system. Similarly, U.S. purchasers of securities initially issued overseas in offerings that today would qualify for the Regulation S safe harbor, would under full company registration have Section 11 remedies against the issuer to the extent the flowback is registered and the U.S. purchaser can trace the purchased securities back to the company registration statement. Moreover, again under full company registration, because all ---------FOOTNOTES---------- -[100]-(...continued) company registration offerings. See Documents for Advisory Committee Meeting, November 21, 1995, Tab E (Letter dated November 2, 1995 from the Securities Industry Association to the Advisory Committee at 9-10) (the "SIA Letter"). The Committee has determined to make no recommendation either way concerning this issue. The current statutory provision for contribution, however, provides in essence for economic indemnification with respect to almost all of a potential claim against an underwriter. ==========================================START OF PAGE 92====== affiliate resales (except those that continue to be effected under Rule 144) are registered on the Form C-1 rather than sold in exempt transactions, Section 11 liability would apply with respect to each such sale. Likewise, broker-dealer underwriting firms participating in a registered company's offering would remain subject to Sections 11 and 12(a)(2) liability. In addition, under the shelf registration system, issuers may provide transactional disclosure, including material updating information, in a prospectus supplement rather than by means of a filing included in the registration statement. As a result, investors are denied the core protections of Section 11 regarding such information. As the Commission has noted, "Section 11 ordinarily does not apply to statements omitted from an effective registration statement and subsequently disclosed in a prospectus or prospectus supplement, rather than a post-effective amendment."-[101]- The pilot will make Section 11 more effective than today (both for company registration and shelf offerings, if the Form 8-K requirement is extended to the shelf), since the transactional information disclosed in a Form 8-K filed at the commencement of non-de minimis equity offerings must be ---------FOOTNOTES---------- -[101]- Elimination of Certain Pricing Amendments and Revision of Prospectus Filing Procedures, Securities Act Rel. 6672 (Oct. 27, 1986) [51 FR 39868 (November 3, 1986)]. But cf. Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996) (though not discussing issue, allowing Section 11 (along with Section 12(a)(2)) claim predicated on prospectus supplement on motion to dismiss). ==========================================START OF PAGE 93====== incorporated into the registration statement and thus would be covered by Section 11.-[102]- In addition, the opportunity to avoid preparing and delivering a separate prospectus by incorporating by reference into sales literature or the confirmation of sale, transactional information filed in an Exchange Act report will provide an incentive for issuers to file that information on a Form 8-K, even when not required. In connection with further implementation of the company registration system, including extending the system to a broader class of issuers, the Commission could consider whether it is necessary to extend full Section 11 liability to the information provided at the time of an offering under the company registration system, regardless of whether filed with the Commission on a Form 8-K or in a prospectus supplement delivered to investors. With respect to Section 12(a)(2), some have expressed the view that one of the reasons companies may choose to raise capital in the private markets is the differential liability ---------FOOTNOTES---------- -[102]- Reports filed under the Exchange Act automatically become part of the registration statement and thus are subject to Section 11 liability. See Wielgos v. Commonwealth Edison, 688 F.Supp. 331, 338-40 (N.D. Ill. 1988). However, unless the information represents a fundamental change in the information previously provided in the registration statement, the report will not have the legal effect of a post-effective amendment or a new registration statement or change the effective date for liability purposes. See Regulation S-K Item 512(a) [17 C.F.R. 229.512(a)]; Irving Bank Corp. v. Bank of N.Y. Co., Inc., 692 F. Supp. 172, 176-80 (S.D.N.Y. 1988). ==========================================START OF PAGE 94====== standards between the negligence standard of liability in Section 12(a)(2) and the strict liability standard of Section 11.-[103]- After Gustafson, it would appear that only Rule 10b-5 liability may attach to private placements, although it is unclear what impact the decision will have on the number or dollar volume of private placements. The Committee believes that Rule 10b-5 liability will continue to provide significant deterrence to fraud in private placements,-[104]- and that Section 12(a)(2) should continue to be applied as under current law. To the extent an issuer chooses to register transactions under company registration that otherwise would qualify as exempt private placements, the effect of the Gustafson decision on the applicability of Section 12(a)(2) should be minimized since both ---------FOOTNOTES---------- -[103]- Gustafson v. Alloyd Co., 115 S.Ct. 106 (1995). Prior to Gustafson, most practitioners and the Commission believed that Section 12(a)(2) liability applied to secondary market transactions and exempt offerings. As a result, due diligence for private offerings tended to be as extensive as it is for public offerings (see, e.g., Robert F. Quaintance Jr., Getting Comfortable with 'Public- Style' Rule 144A Offerings', INSIGHTS, September 1993, at 8). In its extreme application, Gustafson would mean that Section 12(a)(2) does not apply to private placements. As a result, although underwriting techniques in the Rule 144A market closely resemble that of a public offering, including the absence of negotiations and an opportunity for individual due diligence, purchasers would not receive any of the statutory protections of a public offering. -[104]- Transcript of September 29, 1995 Advisory Committee Meeting at 27-29 (statements of Mr. Sonsini). ==========================================START OF PAGE 95====== Section 11 and Section 12(a)(2) would be applicable. In addition, to the extent that an issuer chooses to use selling materials as the statutory prospectus by incorporating filed information from the Form 8-K, Section 12(a)(2), rather than Rule 10b-5, would apply to those selling materials. B. Due Diligence Under Company Registration The Commission's development of the integrated disclosure system over the last decade and a half has shifted the primary source of key disclosures concerning the company from the sporadic or infrequent disclosures contained in public offering documents under the Securities Act to the updated reservoirs of information regarding a company contained in Exchange Act reports. The gatekeepers have tried to adapt to these changes since the inception of the integrated disclosure system. The underwriter community, in particular, has voiced longstanding concerns regarding the impact of these reforms on traditional due diligence functions.-[105]- The Committee is cognizant of the concerns raised by underwriters and outside directors that market changes have altered the dynamics and ---------FOOTNOTES---------- -[105]- See SIA Letter, supra n.100 (recommending that the Committee and the Commission consider recommending amendments to Section 11 with respect to underwriters to eliminate the requirement that, in establishing their due diligence defense, they prove that they made a reasonable investigation); see also American Bar Association Committee on Federal Regulation of Securities, Report of the Task Force on Sellers' Due Diligence and Similar Defenses Under the Federal Securities Laws, 48 Bus. Law. 1185 (May 1993) (the "ABA Due Diligence Report"). ==========================================START OF PAGE 96====== nature of their relationships with issuers and, consequently, their traditional due diligence functions. In particular, the Committee acknowledges that the tightened time constraints may make it more difficult for underwriters and outside directors to discharge their due diligence obligations. In order to protect investors by maintaining the integrity of the disclosure system, the Committee has concluded that continued emphasis on the due diligence obligations of underwriters and outside directors is critical to maintaining and increasing investor protection. Moreover, between the choices of simply limiting liability for participants versus providing reasonable procedures so that participants can better perform their due diligence obligations and, therefore, as a practical matter limit their exposure by reducing the opportunity for material misstatements to be disseminated to the public, the Committee strongly prefers the latter. Following the lead of the ABA Task Force appointed to study due diligence practices under integrated disclosure and shelf registration,-[106]- the Committee determined that, rather than excusing monitors from their due diligence responsibilities, more guidance regarding their respective responsibilities should be furnished by the Commission. The Committee recommends providing additional guidance, within the framework of current Commission Rule 176, that would elaborate upon the factors courts ---------FOOTNOTES---------- -[106]- See ABA Due Diligence Report, supra note 105. ==========================================START OF PAGE 97====== may consider as indicia of "reasonable investigation" and/or "reasonable care" for purposes of determining whether the particular defendant has met its due diligence obligations under Sections 11 and 12(a)(2) in the context of an offering made under the company registration system.-[107]- The Committee determined not to recommend that additional Commission guidance regarding the due diligence function take the form of a safe harbor from liability or an evidentiary presumption. The Committee agrees with the district court in Escott v. BarChris, which stated that "[i]t is impossible to lay down a rigid rule suitable for every case defining the extent to which such verification must go. It is a question of degree, a matter of judgment in each case."-[108]- To the extent changes in the offering process require greater reliance on other gatekeepers in order to deter fraud and provide incentives for the highest quality disclosures, the Committee believes that underwriters and outside directors should ---------FOOTNOTES---------- -[107]- The ABA Due Diligence Report recommends extension of Rule 176's enumeration of "relevant circumstances" to an underwriter's or agent's exercise of "reasonable care" under Section 12(a)(2). See id. Notably, Section 12(a)(2) does not refer to the need for a "reasonable investigation," and consequently raises the question about whether Congress intended to require a lesser standard of care. For a discussion of legislative history and case law on whether different levels of due diligence are required, see id. at 1190. -[108]- Escott v. BarChris Construction Corporation, 283 F. Supp. 643, 697 (S.D.N.Y. 1968). ==========================================START OF PAGE 98====== be able to take the efforts of those other persons into account in evaluating the appropriate due diligence they should perform at the time of the offering. This facts and circumstances approach to due diligence was embraced by the Commission when it adopted Rule 176 in response to identical concerns raised by the underwriting community and others when the integrated disclosure system was implemented in 1982: For example, the Commission believes that a court would not expect the investigation undertaken in connection with a short form registration of a seasoned company to be the same as that which would be reasonable in connection with an initial public offering.-[109]- Under the recommended approach, as under current Rule 176, persons who are eligible for the due diligence/reasonable care defenses codified in Sections 11 and 12(a)(2), respectively, could consider the due diligence inquiries of those persons in the best position on an ongoing basis to oversee the quality and accuracy of the requisite disclosure in determining the degree of due diligence investigation they themselves need to perform to satisfy their statutory obligation. As under current Rule 176, the factors are meant to be illustrative, not exhaustive, and the weight given to each factor necessarily must vary with the facts and circumstances of a particular offering, including whether the offering is a routine financing, or involves equity or debt. As outlined below, this guidance should create incentives for those ---------FOOTNOTES---------- -[109]- Securities Act Release No. 6383 (March 3, 1982), note 101 [47 FR 113800, 11400 n.101]; SIA Letter, supra n.100, at 9. ==========================================START OF PAGE 99====== engaging in due diligence to make better use of others who are in a position to help ensure the quality and integrity of the disclosure -- to the ultimate benefit of investors. The Committee believes SAS No. 71 interim financial reviews by the company's outside auditor to be particularly relevant in this context.-[110]- By recognizing the appropriateness of an underwriter's and outside director's reliance on those reviews in discharging their due diligence duties, the Commission will encourage registered companies to involve this outside monitor more extensively and on a more continuous basis with unaudited information. As a result, widespread use of interim reviews should increase investor confidence in the quality of quarterly reporting. Comfort letters provided by the company's outside auditing firm to the underwriters in accordance with SAS No. 72 also may be relevant. Although the legal effect of an auditor's comfort letter necessarily varies with the audited or non-audited character of the underlying financial information, and the letter alone normally will not be determinative of whether a reasonable investigation was conducted, such a letter nevertheless adds important independent oversight of the issuer's financial reporting in connection with an offering. Consequently, the receipt of a comfort letter appropriately should be recognized as a factor to be weighed in evaluating how a gatekeeper must ---------FOOTNOTES---------- -[110]- See supra pp. 24-28. ==========================================START OF PAGE 100====== perform its due diligence in order to discharge its responsibilities under all the relevant facts and circumstances. 1. Underwriters Although underwriters would not be relieved of responsibility for the accuracy and completeness of the issuer's disclosure, their review at the time of the offering should be facilitated by the continuous review conducted by other monitors as well as the enhanced disclosure practices recommended by the Committee.-[111]- This assistance would be in addition to the other recommendations of the Committee, such as the filing of a Form 8-K at the time of the offering, that are intended in part to facilitate the underwriter's due diligence review at the time of most equity offerings.-[112]- The underwriters' ability to confer with other persons familiar with the issuer as well as with management to assess the scope of their review preserves the underwriters' central, independent role in ensuring the quality of disclosures regarding the securities they bring to market. Accordingly, the Committee determined that (in addition to the factors in the current Rule 176) the relevant factors to be considered in connection with the underwriter's due diligence defense should include the following: (i) The Senior Management Certifications (described above); ---------FOOTNOTES---------- -[111]- Transcript of September 29, 1995 Advisory Committee Meeting at 189-194 (statements of Mr. Sutton and Mr. Elliott). -[112]- See supra p. 23-24. ==========================================START OF PAGE 101====== (ii) The Management Report to the Audit Committee (described above); (iii) Whether other outside professionals have reviewed the relevant documents, for example, pursuant to a review of the issuer's interim financial statements by the company's auditors in accordance with SAS No. 71, the performance of procedures with respect to events subsequent to the date of the audited financial statements in accordance with SAS No. 37, and the receipt of a "comfort letter" under SAS No. 72, or whether the board or a committee of the board received a Rule 10b-5 opinion letter from counsel regarding the non-financial and non-expertized portions of the periodic reports; (iv) The extent of the underwriter's access to their own or outside analysts that have followed the issuer for a significant period of time;-[113]- (v) Whether a board disclosure committee was appointed and the quality of the review engaged in by the disclosure committee; and (vi) The size of the offering, both in absolute and relative terms, vis-a-vis the size of the issuer. Ultimately, however, underwriters bringing offerings to market will continue to have significant responsibility for the disclosures used in connection with that offering. Even apart from the potential for civil liability under Sections 11 and 12(a)(2), an underwriter has a legal obligation under the antifraud provisions of the federal securities laws to have a ---------FOOTNOTES---------- -[113]- See Circumstances Affecting the Determination of What Constitutes Reasonable Investigation and Reasonable Grounds for Belief Under Section 11 of the Securities Act; Treatment of Information Incorporated by Reference Into Registration Statements, Securities Act Rel. 6335 (Aug. 6, 1981) [46 FR 42015 (August 18, 1981)]. ==========================================START OF PAGE 102====== reasonable basis for its recommendations and its belief in the accuracy of the statements contained in the offering materials.-[114]- As a result, notwithstanding the comfort afforded by the proposed guidance regarding the due diligence defense, the underwriter must take care to ensure that it has performed all the procedures and investigations necessary to form a reasonable basis for its belief regarding the accuracy and adequacy of the issuer's disclosures. 2. Outside Directors Certain Committee members expressed particular concern about exposing outside directors to greater liability under the company registration system.-[115]- The Committee believes that outside directors of public corporations currently are not always properly positioned to perform a full investigative function. For example, because of timing constraints characteristic of shelf takedowns, outside directors may not have sufficient time ---------FOOTNOTES---------- -[114]- See In re Donaldson, Lufkin & Jenrette Securities Corporation, Securities Act Rel. 6959 (Sept. 22, 1992); Justin Klein, Underwriter Beware: SEC Brings Proceeding for Failure to Conduct Adequate Due Diligence, INSIGHTS, March 1993, at 17. See also Exchange Act Rule 15c2-12 (Municipal Securities Disclosure) [17 C.F.R. 240.15c2-12]; Municipal Securities Disclosure, Exchange Act Rel. 26100 (September 22, 1988) [53 FR 37778 (September 28, 1988)]; Municipal Securities Disclosure, Exchange Act Rel. 26985 (June 28, 1989) [54 FR 28799 (July 10, 1989)]. -[115]- See, e.g., Transcript of July 26, 1995 Advisory Committee Meeting at 247-52 (statements of Professor Coffee); Concurring Statement of John C. Coffee, Jr., Edward F. Greene and Lawrence W. Sonsini. ==========================================START OF PAGE 103====== to review any disclosure documents other than the Form 10-Ks. Frequent, repetitive equity takedowns, such as those effected pursuant to the at-the-market provisions of the shelf rules, may pose difficult problems for outside directors.-[116]- The potential extension of director liability under Section 11 to transactions that today would be conducted as exempt private placements could exacerbate those concerns for outside directors. Outside directors, however, also are almost uniquely positioned to maintain continuous oversight of the company's disclosures, provided a practical mechanism were established to permit them to do so. The audit committee is an obvious example of such an initiative to formalize the role of outside directors. The Committee sought similar approaches to strengthen the role of outside directors in the disclosure process in order to ensure that the promise of appropriate outside director gatekeeping could be realized. As discussed previously, the establishment of a disclosure committee would provide such a formal mechanism for outside directors to accomplish that goal. The Committee also believes that the outside directors, like the underwriters, should be able to consider management certifications and reports, and the preparation or review of relevant documents by various independent professionals, in determining the appropriate level of due diligence necessary to satisfy the directors' statutory obligation. Specifically, the Committee determined that, in addition to the factors in current Rule 176, the relevant factors ---------FOOTNOTES---------- -[116]- See n. 79 to Appendix A to the Report. ==========================================START OF PAGE 104====== that courts should consider in connection with an outside director's establishment of a due diligence defense should include, but not be limited to, the following: (i) The Senior Management Certifications (described above); (ii) The Management Report to the Audit Committee (described above); and (iii) Whether outside professionals have reviewed the relevant documents, for example, pursuant to a review of the issuer's interim financial statements by the company's auditors in accordance with SAS No. 71 and a "comfort letter" under SAS No. 72, or whether the board or a committee of the board received a 10b-5 opinion letter from counsel regarding the non-financial and non-expertized portions of the periodic reports. C. Conclusion The Committee has determined to preserve, and in the case of all non-de minimis equity offerings expand, the current Section 11 and 12(a)(2) liability scheme and to provide additional guidance regarding due diligence defenses. The pilot gives the Commission a meaningful opportunity to test the company registration system while monitoring the effects on participants of continued exposure to current standards of liability. If experience with the pilot demonstrates that more concrete guidance is appropriate, the Commission could consider further measures in connection with steps towards final implementation of the company registration system. The Committee thus encourages the Commission during the pilot stage to monitor the due diligence practices that evolve generally from the use of company registration, and specifically from the application of the new ==========================================START OF PAGE 105====== guidance, and to evaluate the consequences for due diligence and investor protection. ==========================================START OF PAGE 1====== SECURITIES AND EXCHANGE COMMISSION ADVISORY COMMITTEE ON THE CAPITAL FORMATION AND REGULATORY PROCESSES TERM SHEET FOR PILOT COMPANY REGISTRATION SYSTEM Goals The goals of the company registration system are to: (i) maintain and enhance the protection of investors in the primary markets; (ii) eliminate unnecessary regulatory costs and uncertainties that impede a company's access to capital; (iii) eliminate complexities arising from the need to distinguish between public and private, domestic and offshore, and issuer and non-issuer transactions; and (iv) enhance the level and reliability of disclosure provided to investors in the secondary markets on an ongoing basis, not just when the issuer conducts a public offering. Concept Registration is company, not transaction-based (except for IPOs and other specific transactions). Once meeting eligibility standards, companies register with the SEC and file periodic reports. Routine financings, as well as resales by affiliates and resales of what are currently known as restricted securities, could be consummated without the current SEC review and registration process. Information provided to investors in the marketing of these routine financings would be based on what the market demands and on company and transactional information required to be filed as part of the issuer's periodic reports. The principal distinctions currently existing between public and nonpublic offerings by registered companies (with the resultant formalities and restrictive concepts such as gun- jumping and integration) would be eliminated, because offers and sales by companies already registered with the SEC generally would not be subject to additional transactional registration requirements. ==========================================START OF PAGE 2====== Essential Elements of the Pilot System 1. Disclosure (a) Company Registration Statement An eligible company may file a Form C-1 registration statement disclosing plans to make offerings from time to time on a company-registered basis and registering all sales of all securities.-[1]- Form C-1 generically registers the types of securities and offerings (including resales by affiliates and statutory underwriters, see Section 1(e) below) that are contemplated and incorporates all existing and future periodic reports. Certain exemptions or exclusions from the registration form would be available (see Section 3(b) below). Amendments can be filed to reflect changed plans as appropriate (e.g., where a company changes the manner of financing or amends its charter to authorize a new class of securities). The Form C-1 registration statement also is updated automatically by each filing under the Exchange Act. Only a nominal registration fee would be paid at the time of filing, with the issuer undertaking to pay a fee upon the sale of securities (i.e., pay as you go).-[2]- ---------FOOTNOTES---------- -[1]- A company could effect its transition to the company registration system from the current system simply by electing to be governed under and complying with the company registration system requirements. To the extent the company currently has restricted securities outstanding, the company could elect, as part of its transition to a company registration system, to register any or all of its outstanding restricted securities for resale on the Form C-1 (and pay the applicable fee and execute a qualified indenture in the case of debt securities at that time) or merely allow the restricted securities to retain that status until the expiration of the Rule 144 restricted periods (three years, but recently proposed to be shortened to two years; limited resales allowed after two years, recently proposed to be shortened to one year). -[2]- There are various mechanisms to achieve this result within the current statutory framework: Once the Form C-1 has becomes effective, it could serve as an evergreen registration statement for offers and sales of securities. Alternatively, the effective date of the Form C-1 with respect to a specific offering could be delayed until an (continued...) ==========================================START OF PAGE 3====== (b) File and Go Sales could be consummated upon the filing with the Commission of disclosure regarding the specific offering of securities and the payment of a transaction-based fee. (Prospectus delivery requirements ---------FOOTNOTES---------- -[2]-(...continued) amendment is filed regarding that transaction. Another alternative would be to have the Form C-1 go effective upon filing, but require another abbreviated registration statement to be filed at the time of the transaction. In any case, the Form C-1 could serve as the basis for multiple offerings, applicable statutes of limitation periods would run commencing from the time of sales made under the form, and the fee would be paid at the time of the particular sale. ==========================================START OF PAGE 4====== are discussed below.) The transactional information would consist of the following, to the extent material and otherwise not previously disclosed: description of securities/pricing plan of distribution, experts, and underwriter information summary financial and dilution information/pro formas actual use of proceeds risk factors material changes Thus, at least the same level of public disclosure on file with the Commission concerning registered offerings that currently exists today for seasoned issuers would be maintained under a company registration scheme. The manner in which the transactional information could be filed with the Commission will depend on the nature of the offering. In equity offerings (including offerings of convertible debt and warrants) over the specified threshold (e.g., 3 percent of public float), the issuer would file a Form 8-K, which would be incorporated into the registration statement. The Committee recommends that this requirement apply to non-de minimis equity shelf offerings by non-company registrants as well. The purpose for the Form 8-K filing is to facilitate due diligence inquiries by underwriters and other offering participants, and to ensure full coverage of Section 11 statutory liability to this information, which would automatically be incorporated into the registration statement. The Form 8-K would be filed a reasonable time in advance of the offering (as specified by Commission rule, e.g., one to three business days), where necessary to provide the market with adequate notice of material developments. The transactional information need not be filed on a Form 8-K until the time of the offering. With respect to all other offerings, the issuer will have a choice regarding the manner in which the transactional disclosure will be filed with the Commission. The issuer could voluntarily file a Form 8-K, as described above; alternatively, the issuer could merely file the prospectus supplement containing the required information when that information is delivered to investors. The information contained in the prospectus supplement normally would not be part of the registration statement. This latter method of filing is consistent with practice under shelf registration today. Neither the Form 8-K nor the prospectus supplement normally would be subject to prereview prior to the commencement of the offering. ==========================================START OF PAGE 5====== Consistent with current practice relating to shelf offerings, information representing a fundamental change in the information regarding the issuer previously disclosed by the issuer would be made by an amendment the Form C-1 or by a Form 8-K or other Exchange Act filing; a prospectus supplement disclosing the fundamental change alone would not suffice. Other types of material developments, however, could be provided either in the Form 8-K Exchange Act filing prior to the offering or as part of the prospectus supplement, as described above. In either case, the issuer's public disclosures must be current at the time of the offering. (c) Auditor's Consent Consistent with current practice under the shelf registration system, an auditor's consent would not have to be filed with each sale or takedown off the company registration statement. An auditor's consent to the use of its report would be dated as of or shortly before the effective date of the registration statement (as updated for the filing of audited financial statements on Form 10-K or other fundamental changes) and would have to be on file at the time of the offering. The auditor could consent to incorporation of its audit report into the company registration statement at the time the Form 10-K containing its audit report is filed by including a currently dated consent in the Form 10-K. That consent (as of the registration statement's effective date), unless withdrawn by the auditor, would be applicable to all offerings pursuant to the Form C-1 until the issuance of a new set of audited financial statements or other fundamental changes that update the effective date of the registration statement. Alternatively, the consent could be filed and currently dated for a specific issuance of securities or conditions could be attached to its use. (d) Prospectus Delivery Delivery of the transactional information could be accomplished either by incorporation by reference or by actual delivery, depending on the size of the offering and other factors. The prospectus would not be subject to prior staff review except in the case of "extraordinary securities transactions," as defined below. These different levels of transactions essentially fall into three tiers: Tier One: In "routine" transactions, an issuer could incorporate information contained in the Form C-1 registration statement and filed reports, including the transactional information filed on a Form 8-K, into a document serving as the prospectus, such as the confirmation or selling materials, that is then distributed to investors, ==========================================START OF PAGE 6====== thereby satisfying in any of these cases the prospectus delivery requirement. Any material company developments to be incorporated must be filed on the Form 8-K a reasonable time prior to the dissemination of the prospectus incorporating the information (e.g., one to three business days) to provide the market an opportunity to absorb the information. Otherwise, as today, the information must be delivered physically as part of the formal prospectus, which is filed simultaneously with the Commission. Tier Two: In "nonroutine" transactions, the issuer would be required to prepare and deliver a formal prospectus containing transactional and, where appropriate to update disclosures, company information. The prospectus would be filed (in addition to or as part of the mandated Form 8-K in non-de minimis equity offerings) with, but would not be subject to registration or prior review by, the SEC.-[3]- Information previously provided in selling materials or in a formal prospectus need not be redelivered. Nonroutine transactions would consist of any single transaction increasing, or potentially increasing, the issuer's outstanding voting securities by more than 20%. The Commission could adopt a similar standard for offerings of other equity and senior securities. The offering of a new class of securities would require actual delivery of information specific to that security (e.g., terms and description of the security, investment risks specific to that security). Actual delivery of information generally of interest only to purchasers in the offering and not the market (such as underwriter discount information or security specific information) could be provided as part of the confirmation. ---------FOOTNOTES---------- -[3]- However, other than in the case of underwritten offerings for cash, exchange listing requirements would require shareholder approval of these offerings, thus creating an opportunity for SEC review of the disclosure materials under the proxy rules. ==========================================START OF PAGE 7====== In those cases where formal prospectus delivery is mandated, the prospectus must be delivered prior to the investors agreement to purchase. To the extent written selling materials that do not satisfy prospectus disclosure requirements are distributed to investors in the course of the offering, a prospectus containing the mandated information would have to be delivered prior to or simultaneous with the selling materials, consistent with current statutory and regulatory requirements. An issuer could avoid delivery of a statutory prospectus by either including or incorporating the required information into the selling materials and treating the selling materials as the statutory prospectus. That approach, however, would subject those materials to liability under Section 12(2) of the Act. Actual delivery of the prospectus information would not be required in the case of sales to accredited investor purchasers, with the expectation that these investors will demand the information they require. This would be consistent with the requirements under Regulation D and Rule 144A today. Tier Three: In "extraordinary transactions," a post- effective amendment to the Form C-1 would be required and would be subject to SEC staff review of the transactional information. The same prospectus delivery requirements as in Tier Two transactions would apply. These transactions would include any financing, merger, material acquisition or other restructuring transaction involving a company's issuance of securities that results in an increase, or potential increase, of at least 40% of the outstanding voting securities. (e) Affiliate and Underwriter Sales In cases where all sales by an issuer are registered on the Form C-1, there is a far reduced concern about the potential use of conduits as a means to distribute unregistered shares into the market. Accordingly, in the case where an issuer elects to cover all sales under the company registration statement, a more ==========================================START OF PAGE 8====== narrow application of the registration and resale requirements would apply.-[4]- The class of persons subject to the affiliate resale limitations would include only the CEO and inside directors and, as a rebuttable presumption, perhaps holders of 20% of the voting power, or 10% of the voting power with at least one director representative on the board, and any representatives of such holders. These affiliates could continue to sell without registration under the existing provisions in Rule 144 for affiliate sales. Sales by these affiliates exceeding the Rule 144 limits would be registered as resales under the Form C-1. An issuer could control the sales of affiliates by declining to file a prospectus supplement or a Form 8-K to complete the registration process at the time of the secondary offering (just as an issuer can refuse to grant registration rights under the current system). Significant shareholders could resell without restrictions if they can rebut the presumption of control arising from their holdings. Contractual resale restrictions also would provide a means for an issuer to control resale activities of its insiders and significant shareholders. Resales by statutory underwriters for issuers and affiliates would be registered under the Form C-1. A statutory underwriter for the purpose of offerings registered under the Form C-1 would consist of a person engaged in the business of a broker-dealer (regardless of whether or not registered as such) acting on behalf of an issuer or affiliate in a distribution. 2. Eligible companies The system would be phased in and made available on an experimental basis. The pilot would be voluntary; eligible companies could elect to opt in as desired. It would begin with larger, more seasoned issuers eligible to elect to be covered. Once the election is made, a company can opt out ---------FOOTNOTES---------- -[4]- An issuer also may elect to maintain the current private placement exemption for sales of equity securities (see Section 3(b)(iii) below). If an issuer elects to maintain such exemption, the current applicability of the affiliate and statutory underwriter resale limitations, as opposed to the narrower approach as described herein, would continue to apply. ==========================================START OF PAGE 9====== by withdrawing the Form C-1, but would not be eligible to use the Form again for a period of two years. During the pilot stage, eligibility would be limited to a senior class of S-3 companies-[5]- that have a (a) Public float of $75 million; (b) Reporting experience of two years; and (c) NYSE, Amex or NMS listings. This final requirement would provide the benefit: (i) of adding an overlay of listing standards, including the agreement to provide prompt disclosure of material developments; and (ii) of minimizing the amount of coordination with the states necessary to implement the pilot stage due to the common Blue Sky exemption for offerings by listed companies. These standards collectively reduce the number of companies eligible to use the Form C-1 during the pilot stage to approximately 30% of public companies. A subsidiary of an eligible company could issue debt that is guaranteed in full by the parent under the parent's Form C- 1. Closed-end investment companies would not be eligible. Foreign issuers would be eligible for the pilot if they undertake to file the same forms and meet the same requirements as domestic companies. The Commission should consider whether reconciled interim financials filed on Form 6-K on a semi-annual basis should suffice (this is the current practice for foreign issuers using the shelf on Form F-3). To be eligible, issuers must undertake to adopt measures that would enhance secondary market disclosure (as discussed below in Section 4). Noncompliance with the conditions as of the time of the Form 10-K update would result in the loss of eligibility (for two years) to make offerings pursuant to ---------FOOTNOTES---------- -[5]- S-3 companies generally include only those that have a $75 million public float; one-year reporting history; and are current with respect to their reporting requirements and certain fixed obligations. ==========================================START OF PAGE 10====== the Form C-1. In addition, the issuer must be current with respect to its Exchange Act filing obligations before commencing an offering off the Form C-1. Eventually, the system would be made available to all publicly held companies (that have engaged in an IPO), but with additional enhancements or conditions, including prospectus delivery, pre-sale notice or filing requirements, prereview annual financial information, etc. 3. Transactions Covered As noted, the Form C-1 registration statement would register all sales of all securities made by the issuer or its affiliates (subject to exceptions and exclusions as discussed below, see in particular Section 3(b) below).-[6]- Since sales made subject to the Form C-1 would be registered, the securities would be freely tradeable. Thus, under the proposed system, registered companies would waive transactional exemptions such as those for private offerings (4(2), and Reg. D (Rules 505 and 506)), intrastate offerings (3(a)(11) and Rule 147), issuer exchange offers (3(a)(9)), and transactions pursuant to fairness hearings (3(a)(10)).-[7]- The inclusive nature of the Form C-1 registration statement ensures that issuers could not use conduits to avoid liability that results from registration of securities. Treating all sales as registered generally eliminates the need for concepts of restricted securities, integration, general solicitation, flowback, etc., with respect to securities issued by companies opting into the system. Where an issuer is not prepared to disclose publicly a material development or other material information that would otherwise be required to be disclosed in a registered offering, the issuer still can sell pursuant to the Form C-1 by providing the information to the purchaser(s) on a ---------FOOTNOTES---------- -[6]- To the extent relevant during the transitional stages, secondary offerings of restricted securities by existing security holders could be made pursuant to the system as well. -[7]- It may be necessary to preserve the Section 3(a)(10) exemption for involuntary distributions pursuant to court orders, such as settlements of class actions. ==========================================START OF PAGE 11====== confidential basis with a lock-up agreement. The Commission would provide a full or partial exemption from its filing requirements for these limited placements if made to sophisticated investors, and accompanied by measures to ensure that those securities are not traded until full disclosure is provided to the public (as would be necessary under Rule 10b-5). In this manner, once the issuer makes public disclosure of the otherwise confidential information or the information is no longer material, the purchaser would have freely tradeable securities without any additional holding period or registration requirements. In addition, unlike an exempt offering, the liability provisions of the Securities Act would attach to the securities originally issued in the limited offerings. ==========================================START OF PAGE 12====== (a) Exclusions: (i) IPOs: Only companies that have conducted a registered public offering of debt or equity would be eligible to use the company registration form. (ii) Complex securities not valued on the basis of the issuing company's business and financial information, such as asset backed or special purpose issuers. Complex securities that are valued in part on the basis of the issuer's performance, such as structured securities or tracking securities (e.g., GM Series H) could be made eligible subject to special disclosure requirements. (iii) Exempt securities such as commercial paper and bank guaranteed debt. (b) Voluntary Exclusions: (i) Offshore offerings of any securities to non-U.S. persons could be excluded from the Form C-1. However, equity securities would be registered (and a fee paid with respect thereto) on the Form C-1 for purposes of any resales of the securities into the United States as a result of flowback transactions (the fee would be based upon the amount reasonably estimated to flow back into the United States; thus, U.S. purchasers of equity securities initially offered overseas would benefit from the statutory protections to the same extent as if the securities were initially sold in the United States. The statute of limitations would run from the time of the initial overseas sale by the issuer. (ii) Placements of non-convertible debt to institutional investors could be excluded from the Form C-1. (iii) Modified Company Registration -- "Company Lite" The issuer could elect a modified form of company registration that would continue to permit private placements of any of its securities, including equity securities, as well as reliance on the other transactional exemptions. So long as the issuer undertakes to adopt the enhanced disclosure practices, the issuer would ==========================================START OF PAGE 13====== have the benefits of the file and go registration process for its public offerings, the payment of filing fees at time of sale, and most of the other benefits of company registration. Exempt sales would not be integrated with registered sales made pursuant to the Form C-1. However, the securities sold in the private placement would be restricted securities subject to current holding periods and resale limitations. In addition, the new, limited application of affiliate resale restrictions would not apply to securities sold by that issuer -- the current restrictions on affiliate resales would continue to apply. Likewise, the statutory underwriter concept for resale purposes would not be limited to broker-dealer firms in connection with these private placements. This approach would permit issuers to weigh the benefits of registration of all equity sales against the benefits of a continued private placement exemption, including the absence of Section 11 liability for sales made pursuant to such exemption. 4. Disclosure Enhancements Complementing measures to ease issuer access to the market would be measures to improve the level and reliability of secondary market disclosure. The Commission, following the pilot stage, should consider reviewing the enhancements to determine whether it would be desirable to make them applicable to all issuers, or at least those issuers using the shelf registration procedure, rather than having separate requirements applicable only to registered companies. (a) Top Management Certifications Certification to the Commission (not a filed document) would be required of two of the following four officers that they have reviewed the Form 10-K, the Form 10-Qs and any Form 8-Ks reporting mandated events, but not for voluntarily filed 8-Ks, and are not aware of any misleading disclosures or omissions: the CEO, COO, CFO, or CAO. The attestation would be required upon the filing of each such document with the Commission. (b) Management Report to Audit Committee A report prepared by management and submitted to the audit committee describing procedures followed to ensure the integrity of periodic and current reports and, in light of the new narrow application of affiliate resale ==========================================START OF PAGE 14====== restrictions, procedures instituted to avoid potential insider trading abuses (e.g., any requirement that company insiders clear trades with the general counsel's office). This report would be made public as an exhibit to the Form 10-K; the report need not be resubmitted if the described procedures are unchanged. (c) Form 8-K Enhancements Expansion of current reporting obligation on Form 8-K under the Exchange Act to mandate disclosure of additional material developments: (i) Material modifications to rights of security holders (current Item 2 of Form 10-Q); (ii) Resignation or removal of any of top five executive officers; (iii) Defaults of senior securities (current Item 3 of Form 10-Q); (iv) Sales of significant percentage of the company's outstanding stock (whether in the form of common shares or convertible securities); (v) Issuer advised by independent auditor that reliance on audit report included in previous filings is no longer permissible because of auditor concerns over its report or issuer seeks to have a different auditor reaudit a period covered by a filed audit report. For the above items that are required now to be filed on a Form 10-Q, the information therefore would be provided on a current, rather than a quarterly, basis. Moreover, the period within which a Form 8-K must be filed following any mandatory event specified in that form would be accelerated from 15 calendar days to 5 business days. (d) Risk Factors Risk factor analysis disclosure requirements currently required in all Securities Act filings would be added to the Form 10-K (and would thereby be capable of being incorporated by reference). The caption could be modified to be "Significant Considerations in Connection with Investing in Company Securities," instead of "Risk Factors," when the analysis is presented in the Form 10-K. ==========================================START OF PAGE 15====== (e) Other Action (Voluntary) Companies under the company registration system also may voluntarily adopt measures such as the creation of a disclosure committee of outside directors, and the obtaining of SAS 71 reviews. Such measures would be included within the list of relevant factors for assessing the adequacy of due diligence in current Rule 176 (see below). ==========================================START OF PAGE 16====== 5. Liability Section 11 Liability The issuer would be subject to strict Section 11 liability to purchasers of securities sold under the company registration statement for materially false or misleading information in the Form C-1 (including all incorporated information such as transactional information filed as part of the Form 8-K). Officers, directors, experts and underwriters likewise would be liable for materially false or misleading statements in the Form C-1 (including the transactional and updating information filed on the Form 8-K and incorporated into the Form C-1) and any post-effective amendments thereto (with the due diligence defenses afforded under current law). This approach does not represent a change in the liability system for public offerings (with the exception of sales by persons who would no longer be subject to resale restrictions and thus who would not have liability under Section 11 for their resales), but represents an expansion of liability to the extent transactions that would otherwise be exempt private placements or flowback from overseas placements are covered by the Form C-1. In addition, because in many offerings the transactional information will be filed on a Form 8-K and made part of the registration statement, rather than merely part of a prospectus supplement as is the practice in shelf offerings today, Section 11 will apply to that disclosure when it has not been applicable under the current scheme. Similar to current law, the Section 11 remedy would extend to all purchasers of securities sold initially under the Form C-1 (subject to statute of limitations and the ability of purchasers to trace securities to the misleading registration statement). Thus, issuers and affiliates cannot avoid liability by placing securities with conduits for resale to the public. Indeed, sham transactions involving strawmen would be deemed registered issuer (or affiliate) sales. Section 12(2) Liability Rather than merely fraud liability, negligence liability for sellers in public offerings would apply to any selling materials serving as a statutory prospectus (i.e., no formal prospectus has been previously delivered) and incorporated documents (in addition to any Section 11 liability that might be applicable to those documents). Likewise, oral communications will continue to be subject to Section 12(2) liability. ==========================================START OF PAGE 17====== Exchange Act Liability Liability under Sections 18 and 10(b) of the Exchange Act and Rule 10b-5 thereunder, would remain applicable for material misstatements or omissions in filed reports or made in connection with the purchase or sale of securities. Due Diligence Guidance To provide incentives for the adoption of improved disclosure practices and to address the expanded Section 11 liability exposure of officers and directors of registered companies, guidance setting forth the criteria for evaluating the adequacy of a non-issuer defendant's Section 11 due diligence in connection with a particular offering would be provided. The goal is to enhance the quality of disclosure and to provide more meaningful guidance regarding the satisfaction by underwriters and directors of their ("reasonable investigation") due diligence responsibilities. Rule 176 currently specifies that a relevant factor is reasonable reliance on officers, employees and directors whose duties should have given them knowledge of the facts. Guidance would be provided to clarify as well the relevant factors that may be considered when such defendants attempt to establish a defense of "reasonable care" to a Section 12(2) negligence claim. (a) Both underwriters and outside directors could take into account (i) the certifications of senior management (e.g., CEO, COO, CAO and CFO) discussed above, and (ii) the Management Report to the Audit Committee discussed above. (b) Underwriters and outside directors also may consider whether other professionals have reviewed the documents, such as a review of the issuer's interim financial statements by the company's auditors in accordance with SAS 71 or other more detailed procedures, subsequent event reviews consistent with SAS 37, and a "comfort letter" under SAS 72, or whether the board or a committee of the board received a Rule 10b-5 opinion letter from counsel regarding non- financial and non-expertized portions of the periodic reports and Form C-1. Use of these measures by the issuer is voluntary and the fact that an issuer does not adopt such practices is not indicative of an inadequate review by offering participants. (c) Underwriters also may consider the extent of their access to analysts (either their own or outside ==========================================START OF PAGE 18====== analysts, and consistent with appropriate "chinese wall" procedures) that have followed the issuer for a significant period of time in determining how much additional due diligence must be performed by the underwriter in order to satisfy the applicable due diligence standard. (d) Underwriters also may consider whether a Disclosure Committee (see below) was established and may take into account the scope of the review engaged in by the Disclosure Committee. (e) These additional factors may be interpreted as indicia of "reasonable investigation"/"reasonable care," but such factors will be illustrative, not exhaustive or conclusive. The degree to which any of such factors will serve as indicators will depend upon the particular facts of the offering (including whether the offering is a routine financing). Need to Monitor Developments The Commission should solicit comment, and monitor developments regarding the due diligence practices of underwriters during the pilot stage, to determine if offering techniques developed under the company registration system adversely affect either investor protection or an underwriter's ability to perform due diligence or create an unreasonable risk of liability for underwriters. The Commission then could consider whether the proposed new rule could be strengthened consistent with the protection of investors, premised perhaps on the underwriter following specified procedures to identify disclosure problems. After experience with the company registration system, consideration could be given to whether the additional due diligence benefits under these provisions could be made available to all registered offerings, not just those made pursuant to the Form C-1. However, such benefits likely should be conditioned on adoption of the mandatory enhancements described in Section 4 above, and extension of liability as described above. Consequently, it is likely that these additional benefits would be applicable only to the company registration system. 6. Delegation to Disclosure Committee The Committee considered, in the course of its deliberations on the company registration model, a separate proposal to expand the role of the outside directors in ensuring the integrity of corporate disclosures. Although not an integral or necessary part of the company registration model developed by the Committee, the Committee determined to recommend that ==========================================START OF PAGE 19====== the Commission endorse a new procedure that would allow (but not require) outside directors to use the issuer's audit committee or a separate committee of one or more outside directors (a "Disclosure Committee") to conduct investigation of the issuer's disclosures. The Committee believes that this proposal has merit whether or not company registration is pursued by the Commission. The Disclosure Committee can perform the investigative function on behalf of all outside directors, so long as: (i) the delegating directors reasonably believe that the member(s) of the Disclosure Committee are sufficiently knowledgeable and capable of exercising the due diligence obligations on behalf of the outside directors (if necessary, with the assistance of their professional advisers) and with adequate resources, i.e., the delegation must be reasonable; (ii) the delegating directors maintain appropriate oversight of the Disclosure Committee (including by requiring the Disclosure Committee to report to the Board on the procedures followed to ensure the integrity of the disclosure) and reasonably believe that the Disclosure Committee's procedures are adequate and are being performed; and (iii) the delegating directors reasonably believe that the disclosure is not materially false or misleading. 7. Summary of Benefits of the Proposed Company Registration System (a) Benefits to Issuers and Affiliates Speed of access to market: market considerations, rather than regulatory concerns, will govern timing -- elimination of mandatory waiting period and Commission staff review that now add cost and uncertainty. Greater flexibility to go to market more often in lesser amounts, in light of lower transaction costs and less delay and uncertainty -- adoption of "just in time capital" techniques. Elimination of the potential negative price impact known as "market overhang," that may still result from registering equity securities on a universal shelf for many issuers. ==========================================START OF PAGE 20====== Greater flexibility in determining nature of marketing efforts -- timing and content of prospectus driven by informational needs of investors, not the need to prepare and deliver after-the-fact compliance documents determined by regulation. Elimination of a separate registration requirement for acquisitions. Payment of filing fees at time of sale, rather than in advance (as in the case of shelf offerings). Reduction or elimination of concerns regarding gun-jumping, integration, general solicitation, restricted securities, and other constructs developed over the years to maintain the separation of the public and private markets. Elimination of discount attaching to sale of restricted securities in private markets. Lower risk premiums paid on cost of capital as a result of enhanced disclosure practices. (b) Benefits to Investors Disclosure enhancements will result in better due diligence practices and raise level and reliability of corporate reporting, benefitting purchasers in both primary offerings and in the secondary market. Greater flexibility in negotiating transactions due to elimination of regulatory constraints (eliminates timing constraints, fungibility constraints, resale restrictions, etc.). Protection afforded by registration provisions, including statutory remedies, potentially extended to broader class of transactions that otherwise would be conducted outside those protections, such as private placements or flowback of securities from overseas offerings. Full liquidity for what otherwise would be privately placed securities. In contrast to the prospectus supplement procedure currently used in shelf offerings, transactional information and material development disclosures ==========================================START OF PAGE 21====== would be covered by Section 11 liability and provided to the trading markets in a more timely fashion. Lower costs of capital raising incurred by issuers will inure to the benefit of the issuer's shareholders through greater productivity and profits. Improved prospectus disclosure that permits issuers to prepare offering documents containing clear and concise information tailored to the needs of investors and the nature of the transaction. ==========================================START OF PAGE 22====== (c) Benefits to Underwriters, Officers, and Directors Elimination of registration requirements and resale restrictions with respect to most directors and officers that are imposed as a result of their status as "affiliates." Better opportunity to perform adequate due diligence due to Form 8-K filing requirements. Significantly better guidance as to what constitutes a reasonable investigation in the context of integrated disclosure and streamlined offering processes. UNITED STATES SECURITIES AND EXCHANGE COMMISSION CHARTER OF THE SECURITIES AND EXCHANGE COMMISSION ADVISORY COMMITTEE ON THE CAPITAL FORMATION AND REGULATORY PROCESSES Preamble In accordance with the terms and provisions of the Federal Advisory Committee Act, as amended, 5 U.S.C. App., Chairman Arthur Levitt, with the concurrence of the other members of the Securities and Exchange Commission ("Commission"), hereby establishes an Advisory Committee to advise the Commission regarding the informational needs of investors and the regulatory costs imposed on the U.S. securities markets. Charter Pursuant to Section 9(c) of the Federal Advisory Committee Act, and by direction of the Chairman of the Commission, with the concurrence of the other members of the Commission: (A) The Advisory Committee's official designation is the "Securities and Exchange Commission Advisory Committee on the Capital Formation and Regulatory Processes." (B) The Advisory Committee's objective is to assist the Commission in evaluating the efficiency and effectiveness of the regulatory process and the disclosure requirements relating to public offerings of securities, secondary market trading and corporate reporting, and in identifying and developing means to minimize costs imposed by current regulatory programs, from the perspective of investors, issuers, the various market participants, and other interested persons and regulatory authorities. (C) The Advisory Committee shall operate on a continuing basis until the Chairman of the Commission, with the concurrence of the other members of the Commission, determines that its continuance is no longer in the public interest, subject to paragraph (I) of this charter, set forth below, and Section 14(a)(2) of the Federal Advisory Committee Act. (D) The Chairman of the Commission, or his designee, shall receive the advice of the Advisory Committee on behalf of the Commission. (E) The Commission shall provide any necessary support services. (F) The duties of the Advisory Committee shall be solely advisory and shall extend only to the submission of advice or recommendations to the Commission. Determinations of action to be taken and policy to be expressed with respect to matters upon ==========================================START OF PAGE 2====== which the Advisory Committee provides advice or recommendations shall be made solely by the Commission. (G) The estimated annual operating costs in dollars and staff-years of the Advisory Committee are as follows: (1) Dollar Cost: $20,000 per year, for the travel, per diem, and miscellaneous expenses of Advisory Committee members and Commission personnel. (2) Staff-Years: 3 staff-years, per year, of Commission personnel time on a continuing basis. (H) The Advisory Committee shall meet at such intervals as are necessary to carry out its functions. It is estimated the meetings of the full Advisory Committee generally will occur no more frequently than nine times; meetings of subgroups of the full Advisory Committee will likely occur more frequently. (I) The Advisory Committee shall terminate at the end of one year from the date of its establishment unless, prior to such time, its charter is renewed in accordance with the Federal Advisory Committee Act, or unless the Chairman, with the concurrence of the other members of the Commission, shall direct that the Advisory Committee terminate on an earlier date. (J) This charter has been filed with the Chairman of the Commission, the Senate Committee on Banking, Housing, and Urban Affairs, the House Committee on Commerce, and furnished to the Library of Congress on February 24, 1995. __/s/______________________________ Arthur Levitt Chairman UNITED STATES SECURITIES AND EXCHANGE COMMISSION CHARTER OF THE SECURITIES AND EXCHANGE COMMISSION ADVISORY COMMITTEE ON THE CAPITAL FORMATION AND REGULATORY PROCESSES Preamble In accordance with the terms and provisions of the Federal Advisory Committee Act, as amended, 5 U.S.C. App., Chairman Arthur Levitt, with the concurrence of the other members of the Securities and Exchange Commission ("Commission"), hereby renews an Advisory Committee to advise the Commission regarding the informational needs of investors and the regulatory costs imposed on the U.S. securities markets. Charter Pursuant to Section 9(c) of the Federal Advisory Committee Act, and by direction of the Chairman of the Commission, with the concurrence of the other members of the Commission: (A) The Advisory Committee's official designation is the "Securities and Exchange Commission Advisory Committee on the Capital Formation and Regulatory Processes." (B) The Advisory Committee's objective is to assist the Commission in evaluating the efficiency and effectiveness of the regulatory process and the disclosure requirements relating to public offerings of securities, secondary market trading and corporate reporting, and in identifying and developing means to minimize costs imposed by current regulatory programs, from the perspective of investors, issuers, the various market participants, and other interested persons and regulatory authorities. (C) The Advisory Committee shall operate on a continuing basis until the Chairman of the Commission, with the concurrence of the other members of the Commission, determines that its continuance is no longer in the public interest, subject to paragraph (I) of this charter, set forth below, and Section 14(a)(2) of the Federal Advisory Committee Act. (D) The Chairman of the Commission, or his designee, shall receive the advice of the Advisory Committee on behalf of the Commission. (E) The Commission shall provide any necessary support services. ==========================================START OF PAGE 2====== (F) The duties of the Advisory Committee shall be solely advisory and shall extend only to the submission of advice or recommendations to the Commission. Determinations of action to be taken and policy to be expressed with respect to matters upon which the Advisory Committee provides advice or recommendations shall be made solely by the Commission. (G) The estimated annual operating costs in dollars and staff-years of the Advisory Committee are as follows: (1) Dollar Cost: $20,000 per year, for the travel, per diem, and miscellaneous expenses of Advisory Committee members and Commission personnel. (2) Staff-Years: 1 staff-year, per year, of Commission personnel time on a continuing basis. (H) The Advisory Committee shall meet at such intervals as are necessary to carry out its functions. It is estimated the meetings of the full Advisory Committee generally will occur no more frequently than 5 times; meetings of subgroups of the full Advisory Committee will likely occur more frequently. (I) The Advisory Committee shall terminate on September 30, 1996, unless, prior to such time, its charter is renewed in accordance with the Federal Advisory Committee Act, or unless the Chairman, with the concurrence of the other members of the Commission, shall direct that the Advisory Committee terminate on an earlier date. (J) This charter has been filed with the Chairman of the Commission, the Senate Committee on Banking, Housing, and Urban Affairs, the House Committee on Commerce, and furnished to the Library of Congress on February 21, 1996. __/s/________________________________ Arthur Levitt Chairman