I am Tom Stewart-Gordon, for five years I have been the editor of SCOR Report a newsletter which closely follows direct public offerings (offerings sold by the issuers under Rule 504, Regulation A, 3(a)(11), SB-1 and SB-2). During that period we have gathered information on more than 1,300 companies which have attempted to file SEC exempt public offerings, including where they registered, how much they attempted to raise, how successful they were and how they sold their offerings. Shortly before the Commission came out with its proposed rule change, we reviewed the 6,087 companies listed on the OTC Bulletin Board at the time and found 57 which had gone through state registration since 1990. On May 26, we sent a list of those 57 companies to the Commission and asked if any of them were involved in micro cap fraud. As of today, July 1, we have had no response. However, since none of those companies has been mentioned in press reports of micro cap fraud, there would seem to be very little problem with state-registered transactions. While I realize that the Commission has been put under quite a bit of pressure by press reports and Congressional inquiries, it is not clear to me that micro cap fraud is as big a problem as it would seem. Among the more than 1,300 companies which have registered at the state level, I know of only five problems. Two involved unauthorized paying of staff out of proceeds when cash flow did not grow as anticipated. One involved a missed communication between the issuer and the regulators. The remaining two were deliberate failures to disclose material information. None of those cases involved the abuses Release 33-7541 is supposed to fix. If that were the entire situation, they certainly would not be enough to merit a Business Week cover story, Senate hearings and a letter from Rep. John D. Dingell (D-IL) requesting a remedy. If there is a serious problem, it involves sales practices rather than registration, and sales people (NASD members and non-members) rather than issuers. NASAA and the NASD recognize micro-cap fraud as a sales practices and listing standards problem in the secondary market and have taken steps to address it in those terms. With Release 33-7541, the Commission has chosen a circuitous and remote, redundant and ineffective, remedy. The problem, as I see it, is that for a number of reasons, issuers can rely on Rule 504 at the federal level to make private placements of freely transferrable securities in a number of states. This has created two problems. The first is that since the transaction, and not the securities, are exempt, there are no reporting requirements to safeguard investors in secondary markets. That is the area which NASD has focused on. The second problem is that Rule 504 permits general solicitation and advertising of unregistered transactions. As I understand the rationale behind requiring issuers who wish to sell stock to the general public to register their offering, and permitting those who will restrict their sales to people the issuer knows, it is the distinction between selling to acquaintances and to strangers. If one is selling to strangers, those strangers have every right to expect that someone has seen to it that the offering and the offering company conform to locally accepted business customs and the expectations of local investors. If sales are restricted to those investors who either have amassed a considerable wealth, or who have done business, in some meaningful way, with the issuer before, it is assumed that buyers know what they are getting into and no oversight is necessary. Securities sold privately are precluded from resale for a period of time. Those sold to the general public are usually not. The Commission's proposal to restrict resale of state- registered securities (along with unregistered securities) completely ignores the root of the problem and imposes a penalty, including the taint of suspicion that there is something shady about them on the issuers of state- registered securities. On top of that, since the Commission seems to have forgotten completely the reason 504 securities were granted free trading status. It was thought that a small investor might suddenly find that he cannot wait to harvest his investment and may have to liquidate it quickly. Since it was not envisioned that a secondary market would exist, the mechanism would be an unsolicited sale, with or without a broker. The Commission's proposal removes that measure of investor safety, unless the issuing company wishes to become a reporting company. The whole idea behind the small business measures of the late 1970s and early 1980s was to save small business from the onerous requirements of the Exchange Act. NASD has already suggested a way to end abuses in the organized market. The only thing Release 33-7541 would accomplish would be to make it more difficult for small corporate issuers to sell securities and for small investors to get out of their investment if they have to. For the sharp operators who wish to remain inside the law, the proposal would mean merely going back to Forms D which are a year or more old to find companies to exploit. Since the Commission's records indicate that approximately 1,500 Forms D have been filed under Rule 504 in each of the past several years, there should be no shortage of companies. It could be suggested that requiring OTC Bulletin Board companies to be reporting companies merely shoves the problem down a rung to the National Quotation Bureau. Requiring pink sheet companies to be reporting makes no sense. Since the National Quotation Bureau has been around since 1913, it is safe to assume that it serves a legitimate purpose. To require companies quoted by the service to be reporting companies would destroy the difference between it and the OTC Bulletin Board. Surely there must be a place where the sick, the infirm, the underappreciated and unfollowed can die, be recast, or start out. Although it would certainly be unwise for a small, almost entirely unknown company to trust its stock to the tender mercies of the pink sheets, if that company has registered its primary offering at the state level and wants to, it should be permitted to do so without having to wait for a year to no purpose. NASD members have exclusive access to the pinks. They are the only ones who see the quotes. They execute the trades. Surely it is up to the NASDR to police its members with whatever help and support the Commission and the state securities administrators can provide. If NASDR is unable to do that, perhaps the very concept of a self regulating organization ought to be re- examined. A more fruitful approach to cleaning up micro cap fraud might look closely at the market making process. It seems to me that with the availability of market matching software, perhaps it is time that we moved beyond the thinking that led to the Buttonwood Tree Agreement. Maybe we don't need market makers or specialists at all and can go to an open auction to which anyone can bring his own paddle and not have to rely on middlemen. Other Suggestions The Commission has asked if general solicitation and advertising should continue to be permitted in Rule 504 offerings, and whether the lack of restrictions in this area have been a source of abuse, particularly in finding investors or generating market interest in issuer securities. This is a subject about which I know quite a bit, having monitored the performance of 1,324 companies which have filed 2,728 Rule 504, Regulation A and Intrastate public offerings since 1990. If an offering is registered, then surely the issuer should be permitted to generally solicit and advertise his securities along the lines dictated by the state in which the offerings are to be made. As to whether the Rule 504 exemption should be limited to states which require the preparation and delivery of a disclosure document, that surely ought to be up to the citizens of the state in question. "Would adding these requirements further discourage fraudulent secondary market activity as well as fraudulent offerings under Rule 504?" If the problem is with the brokers, why attack the issuers? "Would the cost to small businesses of restricting the solicitation methods permitted by Rule 504 be outweighed by the benefits from avoiding a taint to Rule 504?" It might well be too late to avoid the taint to Rule 504. Much of the losses sustained by the unwary investors who have fallen prey to micro-cap crooks need never have occurred if the SEC had addressed the problem sooner. In addition to the fact that the potential for problems was widely recognized when the 1992 amendment was proposed, the Division of Corporate Finance cannot say that it did not know there was a problem, because in 1995 I wrote the SEC's Office of Small Business, Division of Corporation Finance pointing out, based on a review of Forms D filed in two years and two years of canvassing the states for small corporate offering filings, that almost all the Forms D filed for two years had been filed by companies which had registered their offerings in no state. "How should offerings made pursuant to certain state exemptions, such as the one recently developed for sales to "accredited investors," be treated? Under this model (which was the rule before 1992), private offerings would continue to be permitted without compliance with this particular type of state registration procedure. Should all provisions of the previous version of the rule be re-instituted, i.e., should publicly offered securities issued under the exemption be unrestricted?" The accredited investor exemption, which permits general solicitation as long as sales are made only to accredited investors as defined by Rule 501a, is an open invitation to abuses since there is no test other than "reason to believe" the potential investor is not lying about his wealth. The NASAA exemption was created largely to enable the Small Business Administration's Angel Capital Electronic Network (ACE-Net), a national computer matching service designed to put entrepreneurs and wealthy investors together. ACE-Net has undergone a number of changes. The conditions NASAA thought it was dealing with when it created the accredited investor exemption no longer apply. More fundamental than that, the basic premise of ACE-Net is open to question. ACE- Net is based on the belief that wealthy individuals actively hunt for investment ideas (rather than having to fend them off) and will invest in companies run by people they don't know. All the studies I have seen indicate that neither of those premises is true. That wouldn't matter if the accredited investor exemption were limited to ACE-Net. It is not. Anyone can put a note on the Internet saying that his company is looking for accredited investors. There is very little chance that he will find any genuine accredited investors and every chance that he will build a list of unaccredited mullets to bombard with other deals. Having opened a floodgate with the adoption of CER 1000, for heaven's sake don't blow up the dam by letting unregistered securities(at any level) be freely tradable. "Should the Commission require that a disclosure document satisfying those information requirements be delivered to non-accredited investors before sale in Rule 504 offerings?" Since the Commission has relinquished registration oversight in favor of the states, surely, it is up to the states to require that investors be given the opportunity to see what they are investing in. "To ensure easy access for all investors, should disclosure documents and other sales materials be required to be provided as an exhibit to the Form D?" It has never been clear to me what purpose Form D serves since failure to file doesn't blow the exemption. Approximately 10% of the people who do file a Form D check every box thereby claiming they have sold the same securities under Rules 504, 505, 506, ULOE, and 4(6) at the same time. If the Commission is going to continue to require Forms D, they certainly should be filed electronically and be made available at no charge so that somebody can actually monitor any worthwhile information they may contain. "Should these documents be provided to the Commission for its information only? What issues would this type of procedure raise under the Freedom of Information Act? Should a confidential treatment process be developed to protect some of the information contained in these documents?" The public must see the public's business being done. Anything submitted to the Commission is clearly the public's business. Government agencies only get into trouble when they attempt to keep things from the public. V. SOLICITATION OF COMMENT - OTHER RULE 504 IMPROVEMENTS "The Commission seeks comment with respect to each of the other facets of the current Rule 504 regulatory compliance scheme. Specifically, does the current Rule serve investors' interests? If not, how could this Rule be further strengthened? Should a lower aggregate dollar amount, such as $500,000, be implemented with different requirements in order to provide a more effective compliance system? Should the current 12-month measuring period be lengthened to 2 years, with or without a change in the aggregate dollar limitation?" The questions are couched in terms of the investor, but the subjects all have to do with the issuer. I would say that since the selling season for a 504 offering is typically a year, the issuer should have to provide fresh financials every 90 days throughout the offering period. I would like to see audited financials once a year, but am willing to let the states decide what they will. The ceiling started out at $500,000 and was raised to $1 million for reasons of inflation more than anything else. I can see no reason to hamstring small companies by forcing them to pinpoint their capital requirements three years out. (One year to draft the documents and register the offering and the two years proposed in the limitation period.) If that change were imposed, companies would stay away in droves. They could not afford to limit themselves. "Should the types of issuers eligible to use the exemption be changed? For example, should particular types of 'penny stock' issues be excluded, e.g., offerings for less than $1 per share? Should issuers with total assets or market capitalization below a minimum amount be precluded from using the rule, e.g., $1 million? Would such a limit be consistent with a stated purpose of the exemption: for raising 'seed capital'?" Not only is this a Procrustean bed, it has nothing to do with the problem the Release says it is attempting to fix. Penny stock and micro cap fraud are secondary market sales practice problems. Rule 504 deals almost exclusively with issuer-sold securities in the primary market. The issuer must be allowed to price his securities to the expectations of his customers. With the exception of California, the states in regional review have set a minimum price of $1.00 per share for SCOR and Regulation A offerings. There is no need for the Commission to concern itself with that issue. As to the secondary market, does a floor price make any sense at all? If the issue's price drops below $1.00 are all shares to be whisked away? If an issue is initially sold for $1.00 a share, is it cause for alarums and excursions if a trade takes place at $0.98? In the case of a company which is only known by the people who own stock, is it evidence of fraud if the price drops to $0.50? If the stock is taken off the market, is there any chance at all that the investors will do otherwise than lose their whole investment? "Does the current rule serve issuers' needs? At the same time we are proposing to tighten the rule, are there other areas of the Rule that we can modify to provide small businesses with flexibility without compromising investor protection? For example, should the measuring period for determining the scope of an offering be shortened to six months? Should the dollar limitation in the Rule be increased to $5 million or some higher dollar amount if accompanied with additional compliance requirements such as specified disclosure requirements or state registration requirements? [ See NASAA's Report of the Task Force on the Future of Shared State and Federal Securities Regulation (October 1997). The Task Force, among other matters, recommended that the Commission raise the offering amount in Rule 504 offerings to $10 million pursuant to its new authority under Section 28 of the Securities Act (15 U.S.C. 77z-3). It also recommended that offerings made in an amount over $1 million be required to be registered in the states where the offering is made.]" As nearly as SCOR Report can estimate, the average investment in a direct public offering is about $2,200. That means a $1 million offering will have about 450 investors. Since there is no reason to believe that a larger offering will elicit bigger checks, a $10 million offering would have 4,500 investors. That large number of investors would probably not be well-served under Rule 504 or Regulation A. A company with that many shareholders probably ought to come under the 34 Act reporting standards. At the risk of repeating myself, the determining factor in deciding whether a public offer should be registered or not should not be the amount raised, but the people from whom it is raised. If it is to be raised from strangers, it must be registered. If it is to be raised from acquaintances and accredited in investors, perhaps the offering needn't be registered. "Do differences in state registration schemes affect the utility of Rule 504?" Yes they do, but they should not be changed. The regional review program and informal consultations among non-regional review states have been able to handle most interstate registration problems. Four years ago SCOR Report surveyed issuers to determine their thoughts on the registration process. More than 90% of the respondents (those who succeeded and those who failed to raise money) said that if they had known how much work was involved, they never would have done one the first time. Last December we asked the same question. Not only did 55.7% of the respondents say they would do another offering, several former SCOR companies have completed Regulation A offerings and were working on SB-2 deals. Almost none of the suggestions for improving the process dealt with the registration process. Clearly, the states are taking care of multi-state offering problems already. Although it should not be a reason not to change the current registration regime, there is very little chance that a small company will sell securities in states where it is not known. Interviews with issuers have shown that 90% of their investors come from within 50 miles of their operations. Making it easier for an issuer to register in a far off state would do the issuer no good and could upset the investment climate in the far off state since local business customs and expectations would be disturbed. Companies like Real Goods Trading, which have legitimate reasons for wanting to offer securities in many states have managed to do it. There is no reason to change. "Do those differences affect the incidence of fraudulent secondary trading? If so, how? Has reliance on state regulation achieved the goals set out by the Commission when it amended Rule 504 in 1992?" I think most people would say that had the Commission is completely responsible for these instances of fraudulent secondary trading by creating an unregistered freely tradable security. Over the years, the states have relinquished secondary trading oversight to the Commission and the SROs As pointed out earlier, the state registered offerings have had very few problems of any sort. "Although improving, has the lack of uniformity of state securities regulation in this area had any impact on Rule 504 offerings?" Yes, it has for the unschooled and unprepared. Those issuers prepared to speak with examiners in advance of filing generally find the process doable and not onerous. Issuers who attempt to dictate conditions to examiners tend to find the process frustrating. Regardless of the wishes of the issuer, the regulator must be mindful of local business customs and regulations which form the basis for local investor expectations. His first duty is to the local investors. He must see to it that they understand the investment opportunities placed before them. That understanding includes conformance with the accepted business framework. "Should public offerings under Rule 504 be limited to only those offerings registered in and made in states participating in NASAA's regional review program?" While the regional review program is very good, it is doubtful that all states will participate. California, for instance. Ohio is on record as not believing any other state can do as good a job at securities regulation. Under its current regime, New York could not participate in a regional review. I have not heard that Tennessee or Minnesota are likely to participate. Texas has yet to join a region and it is not clear that any region would want Louisiana. Since the Commission created Rule 504 long before there was a regional review, it seems odd to me that it would now consider restricting registration to states who participate in them. "Should the Commission take a more active role in monitoring Rule 504 transactions to ensure compliance with the antifraud requirements of the federal securities laws?" Given the statistics mentioned above, I think the Commission may rest easy and continue to trust the states to do their jobs. " Should additional information be mandated in Form D? For example, should Form D be required to indicate the state(s) where the offering was made? Or, should Form D filers be required to amend their filings periodically (whether quarterly, annually or some other increment of time) to disclose: (1) whether they have prepared or provided information to facilitate trading such as the NASD's Form 211, which is required prior to inclusion on the OTC Bulletin Board; and (2) whether they have provided other information to potential or existing market makers for their securities?" Form D is to be filed after the first sale. By that time, the states ought to know where the offering has been registered, that is, unless the Commission is planning to keep the private placement portion of Rule 504. If that is the case, anything the Commission does will not be worth the effort. It can ask for all the information it can think of and we are still likely to have problems. As far as state- registered 504s, most states require a Form U-1 which contains information where the offering is to be (has been) filed. No purpose seems to be served by asking that the same information be put on a Form D. If the information the Commission wants is required on NASD Form 211, why should the issuer have to complete another form? If the Commission would like to ask companies filing under Regulation A to submit a Form U-1 with the rest of their federal filing, and if the SEC would make that information available to the states, in a timely fashion, several state regulators have said that would be useful. In the hope that the foregoing will prove useful in your deliberations, I am, Sincerely, Tom Stewart-Gordon Editor, SCOR Report Dallas, Texas e-mail: tsg@scor-report.com