Law Offices KARR TUTTLE CAMPBELL Founded 1904 A Professional Service Corporation 1201 Third Avenue, Suite 2900, Seattle, Washington 98101 Telephone (206) 223-1313, Facsimile (206) 682-7100 Portland Office 1212 Standard Plaza, 1100 S.W. Sixth Avenue, Portland, Oregon 97204 Telephone (503) 248-1330, Facsimile (503) 222-4429 Please reply to Seattle Office July 11, 1998 Jonathan G. Katz, Secretary U.S. Securities and Exchange Commission Mail Stop 6-9 450 Fifth Street, N. W. Washington, D.C. 20549 RE: Release No. 33-7541, Revision of Regulation D, the "Seed Capital" Exemption File Number S7-14-98 Dear Sir: The comments set forth below are submitted on behalf of this law firm and not on behalf of any Committee or Subcommittee of the American Bar Association ("ABA"). To assist the Securities and Exchange Commission ("Commission") and the Staff in evaluating these comments in appropriate perspective, we set forth a brief summary of our involvement with the development of the Small Corporate Offering Registration ("SCOR"), which has been designed for use in Rule 504 public offerings, and with small businesses that have used SCOR and Rule 504 to raise "seed capital." Commencing in 1986, I served on the Study Group ("Study Group") of the State Regulation of Securities Committee ("Committee") of the Business Law Section of the ABA that with various Committees of the North American Securities Administrators Association ("NASAA") developed the Uniform Limited Offering Registration ("ULOR"), later known by its NASAA name SCOR and its NASAA form designation Form U-7, and in such capacity was a principal draftsperson of that Disclosure Document. As you know, the SCOR Form U-7 was specifically developed for use in the state registration of securities in public offerings that are exempt from registration under the Securities Act of 1933 ("Act") by virtue of Rule 504 of Regulation D, and it was subsequently adopted by the Commission as an alternate disclosure document, "Offering Circular Model A," for offerings qualified under Regulation A or registered using Form SB-1 under the Act. During the course of the development of SCOR, advice concerning its use with Rule 504 was received formally and informally by the Study Group from Mary E. T. ("Mickey") Beach and Richard K. Wulff of the Commission's Office of Small Business, Division of Corporation Finance. Since the adoption of SCOR by the Committee and NASAA, the Committee has continued to monitor the use of SCOR with Rule 504, in coordination with various committees of NASAA, through the Subcommittee on Limited Offerings ("Subcommittee") of the Committee, for which I currently serve as Co-Chair. As the result of my serving on the Study Group and the Subcommittee, I have over the last decade attempted to stay abreast of the use of SCOR in Rule 504 offerings within the United States through contacts with the fellow members of the Study Group and the Subcommittee, the staffs of state securities regulators and NASAA, and consultants to small businesses for limited offerings. This law firm has an active corporate finance (securities law) practice which includes financings of high-technology emerging businesses, many of which are in the software, bio-medical and telecommunications fields. Because of the proximity of the State of Washington to British Columbia and the Vancouver Stock Exchange, we are familiar with the use of Rule 504 and Regulation S in cross-border offerings by emerging developmental-stage U.S. and Canadian companies. I have personally represented a number of clients that have used Rule 504 in SCOR and other limited offerings, made presentations at NASAA annual meeting panels and staff training sessions concerning the use of Rule 504 in SCOR offerings, and participated in various state securities regulator sponsored and other seminar presentations to the small business community on the use of Rule 504 in connection with SCOR and other limited offerings. Our knowledge of small-cap fraud abuses in the use of Rule 504 has been obtained primarily through information obtained informally from regulators and others through these contacts. In the course of our practice we have rendered advice to our small business clients, and to the clients of a West Coast regional accounting firm which we represent in securities matters, concerning proposals that have raised serious questions concerning possible small-cap fraud abuses. Hopefully, our observations will prove useful to the Commission and the staff in considering the proposed changes to Rule 504. Release No. 33-7541 presents a number of interesting questions under consideration by the Commission and the Staff in considering the proposed amendments to Rule 504. We will address only those as to which we believe we may have some meaningful input. First, like many others who advise emerging businesses in their raising of seed capital, we share the Commission's and the Staff's concern that small-cap fraud abuses in public Rule 504 offerings may over time stigmatize those offerings within the financial community as being unsavory and cause public investors to lose confidence in them, thereby impeding their use in raising seed capital by worthy emerging businesses. Accordingly, we applaud the Commission's and the Staff's current efforts to address these abuses in appropriate and effective ways. We believe that Rule 504 has been a useful tool for emerging small businesses in the raising of seed capital, particularly when used in connection with state registered offerings under the SCOR program. We are aware of a significant number of small businesses that have raised seed capital in this manner. Although most have engaged in direct offerings to a specific constituency of customers or other supporters of the particular company, some have used professional selling agents that are members of the National Association of Securities Dealers, Inc. ("NASD"). Many companies that have used Rule 504 to raise seed capital have failed to obtain funding. This, however, does not necessarily mean that Rule 504 (or SCOR) has failed in those offerings, with respect to either the investing public or the small businesses. Indeed, because the disclosures under SCOR are specifically tailored for emerging businesses raising seed capital, the Disclosure Documents are frequently read and understood, and investors have for whatever reason decided not to invest, presumably because a company or the offering is unworthy in their view. This is precisely what Rule 504 and SCOR were designed to do - to provide potential investors with sufficient relevant information to allow them to recognize and invest in the worthy offerings and reject the unworthy - and the rejection by investors some offerings would appear to be in furtherance of the regulatory purpose of the protection of investors. Also, like the Commission's "testing the waters" program, companies that have used public Rule 504 offerings and failed to achieve funding may become sensitized to the shortcomings of their own business plans and management teams, and perhaps the structuring and pricing of the offerings, and can take appropriate remedial steps and then proceed in a more effective manner. One of the criteria of importance to investors in Rule 504 offerings is the ability to freely transfer the securities purchased. In many cases this appears to be more psychological than useful, as investors in Rule 504 seed round offerings are usually seeking to "get in on the ground floor" and participate in the long-term realization of the potential of these companies. Nevertheless, the comfort to seed round investors to be able to freely seek liquidity should they need to do so, particularly in the event of some unforeseen financial need, appears highly significant to the investment decision in these types of financings. It thus appears that the ability of securities sold under Rule 504 to be resold free of legal restrictions on transfer is a critical aspect to its usefulness in the raising of seed capital. This requirement has been noted by a number of persons seeking to make Rule 504 and SCOR offerings more useful in the raising of seed capital. It was the primary reason why Dee R. Harris while serving as the Arizona securities administrator several years ago explored the establishment of the Arizona Stock Exchange, a regulator-overseen trading market for the securities of small public companies. Although we have not been directly exposed to the use of Rule 504 public offerings for the commission of small-cap fraud, it is our distinct impression that no significant number of such offerings that involve small-cap fraud have been registered pursuant to state securities laws, under SCOR or otherwise. Further, we doubt that state registered Rule 504 offerings are likely to be so used in the future because of the detailed scrutiny given them by state securities regulators and the exquisite disclosures required under Form U-7. In our view, a state registered offering is not a good choice for the willful commission of securities fraud by an issuer or a selling agent because those persons and their management are thereby subject to too much detailed regulatory observation and inquiry during the course of the regulatory clearance process. As a vehicle for fraud, a state-registered Rule 504 offering is simply too risky. Our understanding after inquiry on the subject is that in the circumstances in which public Rule 504 offerings have been used to commit securities fraud, the securities have not been registered under state securities laws but either have been sold in states that do not require state registration of such public offerings or have been sold offshore, and then have been resold generally into the U.S. markets in reliance on exemptions from state registration for secondary transactions. Our further understanding is that small-cap fraud abuses are often directly traceable to the activities of rogue registered and unregistered broker-dealers who act as the architects and prime movers in these schemes and bifurcate distributions by illegally "parking" blocks of securities with nominees, followed by improper sales to the investing public through a combination of hype and boiler room tactics. To the extent that these activities are principally responsible for small-cap fraud abuses, they would more appropriately be addressed directly through the regulation of presently registered broker-dealers and enforcement action against unregistered ones. If it is true, as we understand, that state-registered Rule 504 public offerings have not been the source of small-cap fraud abuses, there would appear to be no reason to subject them to the one- or two-year holding periods of Rule 144 by classifying them as "restricted securities," as is proposed in Release No. 33-7541. Indeed, the most detailed and current information concerning a company is apt to be available to the public immediately following the registration process, and it would appear counterproductive to restrict subsequent transfers of securities during the very period in which accurate and complete information is most available. For this reason, we recommend that the criterion in effect for Rule 504 prior to 1992 be reinstated, that is, that free transferability be conditioned upon the registration of the offering in one or more states that require the preparation and delivery of a disclosure document to investors before sale. Because of the widespread use by the states of SCOR in this registration process, we believe that reliable information would be thus made available to investors in the offering and in any subsequent transfers of the securities that may occur. Other, redundant disclosure requirements, such as those provided under Rule 502(b), should not be imposed, as this would likely significantly increase the complexity and costs to small businesses of raising seed capital without any discernable increase in investor protection. The history of Form D suggests that the filing of a disclosure document as an exhibit would be an idle gesture without significant benefit to the investing public as long as Form Ds continue to be filed in paper format because apparently very few persons have historically sought access to the Form Ds that are on file. Retrieval of paper format filed documents is relatively awkward and expensive, and it is unlikely that potential investors would make much use of this process if disclosure documents were required to be so filed as a condition to the availability of Rule 504. Thus, the usefulness to investors of filing paper format disclosure documents with Form Ds would seem unlikely to outweigh the added storage and retrieval costs of such filings to the Commission. The filing of Form Ds electronically on EDGAR requires a degree of office equipment and operator sophistication not now currently available to most small businesses and their lawyers and accountants. Although this firm and many others with a corporate finance (securities law) practice do have that capability, one of the primary purposes behind the development of SCOR for use with Rule 504 was and is to keep the process sufficiently simple to allow its use by non-securities specialists, which is intended to reduce the costs of these offerings. In this regard, we understand that roughly half of SCOR offerings using Rule 504 have been prepared and filed with the assistance of persons who are not specialists in securities law. Vigilant discipline in cost management is an essential aspect to the success of the use of Rule 504 to raise seed capital. As long as the maximum that may be raised under Rule 504 remains at $1,000,000, the economics inherent in the registration process do not allow electronic filings of Form Ds to be made on EDGAR. The $1,000,000 limitation has been in effect for almost ten years, and in view of the existence of inflation during the intervening years, an upward adjustment would now appear justified. We believe that there is merit to the use of EDGAR in the filing of Form Ds and to requiring that the disclosure document used in the state registration be also filed as an exhibit. Indeed, we believe that it might be useful to create a public database providing ongoing current information, that is available to potential purchasers from original Rule 504 investors through the Commission's homepage on the Internet, to require annual filings on EDGAR of audited GAAP financial statements and quarterly filings on EDGAR of interim unaudited GAAP financial statements, without imposing all of the other disclosures under the periodic reporting requirements of Section 12 of the Securities Exchange Act of 1934. Increasing the dollar limit of Rule 504 to $2,000,000 would only constitute a rough adjustment for inflation since the last increase in that limit and would not justify the increased costs of electronic filings. However, if the dollar limit were increased to $5,000,000 or more, the costs of electronic filings of the registration disclosure document and subsequent financial reports could probably be justified. Accordingly, we recommend that the dollar limit for Rule 504 be increased to $5,000,000 or more and that electronic filings on EDGAR, both of the registration disclosure document and of subsequent annual audited and interim unaudited financial statements, be required for offerings of $3,000,000 or more. If the Rule 504 dollar limit were increased to that for offerings exempt under Regulation A, we would recommend that Regulation A be eliminated in its entirety. We do not view regional review of state-registered offerings as a necessary ingredient to the effectiveness of the use of Rule 504 in the raising of seed capital, and we believe that any such requirement to the use of Rule 504 may pressure small businesses to a greater use of expert securities professionals in these offerings, which, as previously noted, may defeat one of the objectives of the SCOR program, that is, to keep the costs of Rule 504 public offerings at as low a level as is feasible consistent with reasonable investor protection. We hope the above suggestions will prove useful in the Commission's and the Staff's consideration of the amendments to Rule 504 proposed by Release No. 33-7541. Very truly yours, KARR TUTTLE CAMPBELL Mike Liles, Jr.