Shearman & Sterling Fax: 212-848-7179 599 LEXINGTON AVENUE Abu Dhabi 212-848-7181 NEW YORK, N.Y. 10022-6069 Beijing Telex: 667290 WUI (212) 848-4000 Budapest Dusseldorf Frankfurt Hong Kong London Los Angeles New York Paris San Francisco Singapore Tokyo Toronto Washington, D.C. December 13, 1996 Mr. Jonathan G. Katz Secretary Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 Securities Act Concepts and Their Effects on Capital Formation Release No. 33-7314 (July 25, 1996) (File No. S7-19-96) Dear Mr. Katz: We welcome the opportunity to comment on the issues raised by the Securities and Exchange Commission (the "Commission") on the above-captioned release with respect to the capital formation process and the regulatory regime governing the offering of securities under the Securities Act of 1933 ("Securities Act"). As evidenced in the wide-ranging proposals of the Advisory Committee on Capital Formation and Regulatory Processes (the "Advisory Committee"), the Task Force on Disclosure Simplification (the "Task Force"), and others, as well as the discussion and debate accompanying consideration of the National Securities Markets Improvement Act of 1996 (the "1996 Amendments"), there is a compelling need to reexamine the regulations under the Securities Act to allow the capital formation process to function more effectively for issuers, underwriters and investors in today's global capital markets. The work of the Advisory Committee has been central to the reexamination of the Securities Act, both in identifying many of the problems arising under the current regulatory scheme and in suggesting various elements of regulatory reform to address these problems. We agree with the Advisory Committee that market developments have outstripped the regulatory process and that there is a pressing need to overhaul the regulations governing securities offerings. We do not, however, support the Advisory Committee's recommendation that the Commission undertake a pilot company registration program. The limited and voluntary nature of the pilot, together with the "company-lite" option, substantially limit its utility as a test of company registration and will provide no relief to the vast majority of public companies that are excluded from the pilot. Indeed, companies proposed to be eligible for the pilot program already have full advantage of a universal shelf; the real issues for company registration are presented by companies that are not currently eligible for shelf registration. We believe the inefficiencies and costs imposed on the capital formation process by outdated regulation call for immediate Commission action on a broad basis and not solely for pilot participants. Moreover, we have substantial concern that the resources needed by the Commission to develop and implement the pilot program would delay the Commission's providing simpler, more targeted reforms that could alleviate many of the more costly inefficiencies for the broad spectrum of market participants. We have not undertaken to suggest a new conceptual model for regulation of the capital formation process, although we support the Commission's initiatives to do so. This letter focuses on those areas that warrant immediate attention and that could be addressed by modest changes to the current rules, even in the absence of developing a new conceptual framework. In the event the Commission determines to proceed with the pilot program, however, we have commented on some specific aspects of the disclosure enhancements proposed as part of that program. I. Current Problems With today's global capital markets characterized by borderless capital flows, instant universal electronic communications and increasing investor demand for information, a regulatory regime based upon the segregation of information by national boundaries or classes of investors is quickly becoming an anachronism. Regulations under Section 5 of the Securities Act that restrict the distribution of information to certain documents or to certain classes of investors undermine the securities laws' goal of full and fair disclosure, and are increasingly meaningless or unenforceable. As a result, the current regulatory process imposes procedures and restrictions that unduly interfere with the efficiency of the capital formation process, impose unnecessary costs and deny investors and the market timely access to important information. Unregistered Transactions The rules governing exempt private placements and offshore transactions condition the availability of the exemptions on the absence of a general solicitation or directed selling effort. Today, issuers and underwriters have no effective way to restrict information concerning the transactions once they have begun their marketing efforts. Information concerning private placements using Rule 144A under the Securities Act ("Rule 144A") is routinely published by the financial press, including the Private Placement Report, Corporate Finance Weekly and The Wall Street Journal, notwithstanding efforts by issuers and underwriters to restrict the distribution of such information to Qualified Institutional Buyers ("QIBs"). Indeed, many Rule 144A placements may be part of global offerings that are widely publicized offshore. And, as the Commission itself recognized in adopting Rule 135(c), the registration safe harbor for announcement of unregistered transactions, public announcements of the transaction may be necessary to keep the market informed of an issuer's material developments. Likewise, the newly adopted reporting requirements for unregistered equity sales by domestic issuers mandate more publicity for unregistered offerings. Services such as Autex have evolved to report on secondary market trading of privately placed securities. By increasing the transparency of the market for privately placed securities, these publications serve a necessary and valuable function for institutional investors. These sources are available to other persons and thereby tend to erode the separate private character of the market for restricted securities. Perhaps nowhere is the artificial and ineffective nature of restrictions on information flow more clear than in the case of offshore offerings as clearly evidenced in the Commission's recent release proposing a safe harbor for offshore press activities. Where publicity and public offering activities are undertaken offshore, the likelihood of news about the offering making its way into the U.S. news is high; there is no effective way to prevent this flow of information. Where there is a concurrent U.S. placement, that likelihood is increased. Indeed, the Commission's own requirements under Rule 12g3-2(b) and Form 6- K mandate submission to the Commission for the public record of documents published by foreign companies for their investors under home country or stock exchange rules. Integration Initially developed as a concept to prevent issuers from circumventing registration obligations by splitting a public offering into several so called "private placements", the integration doctrine has been applied to a wide range of legitimate capital raising activities with little apparent benefit to investors and with significant disruption and cost to issuers. The stock market correction during the summer of 1996 provides a clear example of the adverse consequence to issuers of the overly broad application of the doctrine. While the market correction depressed investor demand for public equity offerings, interest among certain institutional purchasers remained strong. Unfortunately, under current Commission application of integration doctrines, such issuers were unable to recast their public offerings as private placements due to concerns that the Commission would take the position that the placement to the institutions should be integrated with the aborted public offering or that the public offering constituted a general solicitation that would preclude a private placement. Having commenced a public offering, many of these issuers were presented with two basic options: continue the public offering and effectively register the private placement -- a very costly decision in the case of an IPO -- or abandon the public offering and wait six months to undertake a private placement, a choice a number of issuers could not afford. Similar integration concerns arise in side-by-side public and private offerings and in commencing a private placement soon after completing a public offering. Integration concerns also prevent private testing of the waters with institutional investors prior to launching a registered public offering. Little purpose appears to be served in insisting on registration of placements to institutional or accredited purchasers who could clearly buy in a private placement -- simply because the issuer is also engaged in a registered offering. There also appears little investor protection to be gained by precluding an issuer from converting an unregistered, unregulated private offering to a registered public offering subject to the full panoply of disclosures mandated under the Securities Act. Publicity The concern that corporate publicity may be viewed as conditioning the market for sale of securities and, thus, constitute a violation of Section 5 as an unregistered offer, gunjumping or even an illegal prospectus can unduly interfere with issuers' efforts to communicate on a timely and effective basis with their shareholders and the markets. The regulatory scheme should encourage not discourage companies from communicating with their investors at all times, including those periods during which they are selling securities. Concerns about market conditioning are counterproductive to encouraging continuous, comprehensive and timely disclosure that underlies the Commission's integrated disclosure system. Acknowledging that securities offerings are frequently material news, the Commission has provided limited safe harbors for announcements of such offerings (e.g., Rules 135(a)-135(c)). The safe harbors are highly restrictive with respect to the content of such announcements, which seriously limits their utility. For example, a company that issues a press release announcing a significant business combination under Rule 135(a) would be limited to announcing the names of the combining companies, the securities to be exchanged and the basis for the exchange, to fall within the regulatory safe harbor. The goal of the securities laws should be to encourage disclosure of the merger as promptly and fully as possible. However, any discussion of the reasons for, or effects of, the transaction on the company, although clearly important to the market, and to the company's employees, customers, suppliers and other constituencies, would not technically be covered by the safe harbor. To require that the substantive discussion of the transaction only be provided after the filing of the registration statement, and then only in the prospectus, serves neither the goal of prompt nor full disclosure. The Commission has undertaken to encourage and facilitate public companies' use of electronic media to communicate with investors, recognizing its potential to enhance market efficiency by allowing for rapid dissemination of information to investors and financial markets on a more cost efficient, widespread and equitable basis. Yet, legal uncertainties with respect to the status under Section 5 of information placed upon an issuer's Website with respect to a current or prospective offering or even to update financial and business information during the pendency of private and public offerings may thwart the Commission's goal of widespread use of electronic communications for both mandated and informal corporate communications. Research One of the key factors contributing to the transparency and quality of financial information available to the U.S. securities market is the extensive research published by financial analysts on thousands of companies, including companies not registered with the Commission. The importance of such research to the efficiency of the U.S. capital market has long been recognized by the Commission and underlies the safe harbor provisions set forth in Rules 137-139 under the Securities Act. These safe harbor provisions, however, are no longer adequate to assure that investors and the trading markets are provided research on an uninterrupted and timely basis. By their terms, the safe harbors are available only in connection with registered public offerings. While the same public policy and investor interests apply in the case of exempt and offshore offerings, the Commission has not provided comparable safe harbors for research published during private and offshore offerings. As a result, firms may be forced to suspend the publication of research on a company, industry or country pending completion of a distribution. In fact, in the case of Regulation S offerings, Section 4(3) concerns could cause the research blackout to extend in some cases across the whole U.S. market for 40 days following the offering. The result - U.S. investors may be relegated to relying on outdated research that does not reflect an issuer's recent results or material developments. Similar results ensue when a company not eligible to rely on Rule 139(a) undertakes a registered offering. Not only are investors ill served by these Section 5-compelled blackouts, but the client problems and compliance costs for the research firms are enormous. Prospectus Delivery Under Section 5, a purchaser in a registered public offering must be provided a final prospectus with or before receiving a confirmation. In many instances outside the IPO context, no preliminary prospectus is circulated; instead, the investor receives the final prospectus after the sale is made. And in the case of S-3 companies, the final prospectus may contain little, if any, substantive information. The net result under current rules is to require delivery of a document of limited information too late in the process to meaningfully inform investors and at a point that interferes with settlement and clearance. Liabilities Liabilities in connection with registered securities offerings should be based on obligations realistically and fairly imposed. In the case of shelf offerings where issuers can go to market instantly on demand with little if any prior notice to financial intermediaries, there is no realistic opportunity for underwriters to conduct due diligence investigations or to shape the disclosures incorporated into the registration statement and prospectus. Liability statutorily premised on negligence has simply converted into strict liability in such cases. As the Commission continues to enhance and expand issuers' opportunities for "on demand financing," it can no longer ignore the need to modify underwriter liabilities to reflect current market realities. II. Targeted Revisions of Current Regulations Many of the above problems could be alleviated by targeted reform of existing rules while the Commission undertakes to develop a new conceptual model for the regulations of the capital raising process. These targeted revisions incorporate a number of elements included in the Advisory Committee's proposals and the Task Force recommendations. The Commission's new exemptive authority under the Securities Act assures that the Commission has ample authority to implement these reforms. Modification of Registration; Shelf and Other - Adopt the "pay as you go" model with respect to filing fees. This would enable issuers to maximize financing flexibility by registering more securities than are needed at the time without having to incur unnecessary expense. It would also eliminate, to some degree, the market overhang dilemma that has been a problem under the current system, particularly for equity securities. - Allow registration of all securities of an issuer and its majority owned subsidiaries without specification in the registration statement. Requiring specification substantially limits the flexibility of issuers without benefitting investors. - Allow secondary offerings to be registered on an issuer's shelf registration and eliminate the need to name non-affiliate selling shareholders. The inability to register resales is an unnecessary complication; the names of nonaffiliate selling shareholders is of little significance to investors. - Allow "test the waters" solicitations prior to registered offerings. This is consistent with our general view that the Commission should eliminate the registration of offers. At the very least, the Commission should allow testing of the waters with respect to accredited investors who can purchase in unregistered offerings. - Eliminate the "at the market" restrictions of Rule 415(a)(4). These restrictions were put in place as a cautionary measure when shelf registration was initially introduced. Market developments have clearly demonstrated that these restrictions are not necessary to prevent market disruptions and therefore can be eliminated without loss of protection to investors. - Eliminate staff review of shelf eligible issuer registration statements. This would eliminate uncertainty regarding market timing and facilitate timely access to the capital markets. Investors would continue to enjoy the protections afforded by staff review of Exchange Act reports that are incorporated by reference. - Allow delivery of an S-3 prospectus through incorporation by reference into the confirmation. Since little if any substantive information is required to be set forth in an S-3 prospectus, streamlining the process in such manner would lessen the expenses and practical burdens of current prospectus delivery requirements without compromising the principles of full and fair disclosure. Moreover, this approach comports with the concept of constructive delivery and would not materially change the amount of information available to investors. - Modify underwriter liabilities for S-3 offerings. To conform to the realities of the current registration process, the liability scheme for underwriters should take into account the practical limitations that stem from the Commission's promotion of accelerated access to the capital markets on the ability of underwriters to sustain their statutory due diligence defense. - Narrow the definition of "Affiliate." The definition, as historically interpreted, imposes unnecessary restrictions on resales of unregistered securities by persons who do not have a control relationship with the issuer that can reasonably be said to raise the potential for their acting as conduits for unregistered offerings by the issuer. We support the Advisory Committee's proposal in this regard. - Expand the safe harbor for research reports. The safe harbor should apply to all research reports prepared and disseminated in the ordinary course of business for any issuer whether or not it is a reporting company under the Exchange Act so long as the firm has published research about the issuer prior to participating in the distribution. Exemptions - Allow general solicitations for private placements made to accredited investors. Accredited investors do not need protection from unregistered general solicitations. Issuers should be free to make offers in any manner whatever to accredited investors. - Provide a safe harbor from integration for unregistered sales made to accredited investors. The doctrine of integration is designed to protect investors by preventing issuers from circumventing registration requirements. Since accredited investors do not need the protection afforded by integration principles, an unregistered sale to accredited investors is not the type of transaction the integration doctrine was designed to reach. - Eliminate the restrictions on directed selling efforts. As in the case of general solicitations, we believe that registration issues should only be implicated if sales, as opposed to offers, are made to an improper class of purchasers. - Broaden the category of investors eligible for qualified institutional buyer status under Rule 144A. The Commission indicated at the time Rule 144A was adopted that it planned to expand the category of QIBs after experience with the new Rule. Since the experience under Rule 144A has been a success, it is appropriate for the Commission to allow more investors to participate in this growing and active market. - Shorten the restricted period under Rule 144. The restricted period is intended to ensure that persons buying securities under a Section 4(2) exemption are not purchasing with a view to the distribution of unregistered shares on behalf of the issuer. In light of the increasing volatility of the debt and equity markets, and the concomitant exposure to economic risk, the current restrictions are unnecessarily long. Moreover, shortening the holding period would increase the use of the safe harbor and reduce the cost of raising capital in the private market. III. Advisory Committee's Proposed Disclosure Enhancements While we agree with the Commission's goal of assuring the quality of reports mandated by the Exchange Act, we seriously doubt that a number of the enhancements proposed by the Advisory Committee will prove effective or workable. Our specific concerns are discussed below. Expanded and Accelerated 8-K Reporting In general, we agree with the recommendation of the Advisory Committee to expand the events reportable on Form 8-K to include modifications of the rights of security holders and withdrawals of audit opinions and auditor refusals to give consents. A company's Commission filings are a public source of constituent documents that should be updated on a current basis. Given the critical role of auditors in the financial reporting system, the proposal to report currently limitations on use of previously rendered audit opinions does not seem unreasonable. We do not agree, however, with the other items proposed to be added to the Form 8-K: changes in executive officers and defaults on securities. These items do not seem inherently more important than a number of other corporate developments that are not subject to specific Form 8-K requirements. We are not persuaded that there is a general need to accelerate the filing of the Form 8-K reports to five business days. Moreover, we have concerns that, in certain instances, a reportable event may not be anticipated sufficiently in advance and thus preparing complete and accurate disclosure on an accelerated basis may be problematic. The Commission should not adopt a general requirement to report material developments modelled on the existing stock market rules. Mandated reporting of material developments would not be able to provide sufficient flexibility to accommodate companies' legitimate business needs to keep certain pending matters confidential. Such a requirement would put a reporting company in daily risk of violating the federal securities laws for reporting a material development "too late" or for failure to report an event which in hindsight is found material. The quarterly and annual reporting requirements of the Exchange Act, together with stock exchange rules and market demands and updating of information in connection with securities offerings provide adequate incentives for a public company to keep the market informed on a timely basis of material developments. Management Certifications and Management Report to the Audit Committee on Disclosure Procedures We believe the proposed management certifications and report to the Audit Committee will not improve the quality of disclosures provided under the Exchange Act and, therefore, should not be required. Existing regulations already require certain executives to sign Exchange Act reports. An additional requirement for such officers to certify that they have read such reports and do not believe they contain material misstatement or omissions is not likely to change the behavior of those signing such reports. It has been our experience that most corporate officers already take their responsibilities to review Commission filings seriously. Changing the form of the certification will not matter to the few who may not. Likewise, the proposed report to the Audit Committee will simply be generalized boilerplate disclosure of little relevance to investors, and is unlikely to have any real effect on a company's reporting practices. Risk Factors in Form 10-K We have concerns about mandated inclusion of a risk factor section in a company's annual report on Form 10-K because a routine, periodic listing of risk factors runs significant risk of turning into generalized boilerplate, which will be difficult for underwriters and companies to change in the context of subsequent registered offerings. If the Commission mandates inclusion of risk factors in a Form 10-K, it should do so in a manner that will address this problem. Mandated SAS 71 Reviews SAS 71 reviews do improve the quality of financial reporting and should be encouraged by the Commission. We recognize, however, the legitimate cost concerns of smaller companies and, therefore, would support regulatory incentives to undertake such reviews rather than a mandate requiring all filing companies to obtain limited reviews as part of their reporting obligations. Thus, for example, we would support the Commission's including reliance on SAS 71 reviews among the factors constituting reasonable investigation. Disclosure Committee Among the Advisory Committee's suggestions to enhance the quality of Exchange Act reports in the proposal that the Commission encourage issuers to use a committee of outside directors to oversee the company's public disclosures. In essence, the proposal suggests that a committee of outside directors would provide better oversight of the company's disclosure, than does the typical board of directors today. We doubt that such a committee would necessarily enhance the quality of Exchange Act reports and registration statements. While most outside directors review the financial performance and prospects of the companies on whose boards they serve, their focus tends to be the "big picture" items and broad strategic initiatives. Indeed, it is typically a director's expertise in such matters that leads him or her to be selected as a director in the first place. A "disclosure committee" of the board specifically charged with overseeing and investigating the adequacy of a company's disclosures will presumably want to have its own staff and advisers, which is likely to result in a redundancy of efforts within the company. Moreover, it is not clear what outside directors would be prepared to serve on such a committee in light of the potential liabilities under Section 11 to which they would be exposed. Unless the Commission were to address these liability concerns, it seems unlikely that companies would voluntarily use such committees. * * * We appreciate the opportunity to comment on the various proposals to reform the regulation of the capital formation process. The need for change is compelling; as noted above, targeted reforms can and should be implemented expeditiously for the benefit of all market participants. If the Commission or the staff have any questions concerning the foregoing, please call Arbie Thalacker at (212) 848-7085 or Jerry Elliott at (212) 848-7961. Sincerely, Shearman & Sterling