Comments of Keith Paul Bishop on S7-23-01

VIA FEDERAL EXPRESS

Mr. Jonathan G. Katz
Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609

Re: File No. S7-23-01

Dear Mr. Katz:

I am writing to comment on the Securities and Exchange Commission's (the "Commission") proposal to define the term "qualified purchaser" under the Securities Act of 1933, 15 U.S.C. §§ 77a et seq., (the "1933 Act") to implement a provision of the National Securities Markets Improvement Act of 1996, Pub. L. 104-290, 110 Stat. 3416 (Oct. 11, 1996), (the "NSMIA").

1. Background.

I am an attorney in private practice in Newport Beach, California. I am writing in my individual capacity and not on behalf of my law firm or any of its clients.

I previously served as California's Commissioner of Corporations and in that capacity administered and enforced California's securities laws. On July 24 1997, I testified at an oversight hearing on securities litigation abuse conducted by the Subcommittee on Securities of the U.S. Senate Banking, Housing and Urban Affairs Committee. At that hearing, I testified in support of federal legislation adopting uniform standards for class action lawsuits.¹ In my remarks, I emphasized my belief that state securities regulators have an important role in our national securities markets as the local "cop on the beat". However, I also testified that in our national securities markets state laws should be consistent, complementary and competitive with federal securities regulation.² This same analytic framework should be applied in the Commission's analysis of this proposal.

2. The Commission should retain the Rule 504(b)(1)(iii) exemption from registration under the 1933 Act.

a. Rule 504 public offerings. Pursuant to Rule 504(b)(1), small businesses in some states currently may offer and sell securities to accredited investors by means of a public solicitation without registration under the 1933 Act and without limitations on resale (a "Rule 504 Public Offering").³ Rule 504 Public Offerings may be made in the following two circumstances:

Rule 501(b)(1)(i) & (ii). If the issuer registers the offering under a state law that requires the public filing and delivery of a disclosure document to investors before sale; or
Rule 501(b)(1)(iii). If the transaction is effected under a state law exemption from registration that permits general solicitation and general advertising so long as sales are made only to "accredited investors" as defined in Rule 501(a), 17 C.F. § 230.501(a).⁴

The Commission has proposed rescinding Rule 504(b)(1)(iii) if it adopts the proposed definition of "qualified purchaser".⁵ If the Commission does so, small businesses would be prevented from effecting public solicitations without registration under the 1933 Act in situations that they now may do so.

b. Proposed alternative to rescinding Rule 504(b)(1)(iii). Rather than rescinding Rule 504(b)(1)(iii) and eliminating the option of Rule 504 Public Offerings in states that have adopted the requisite exemption from qualification, the Commission should continue to permit Rule 504 Public Offerings. Consistent with the NSMIA, the Commission may do so by providing for a Rule 504 Public Offering exemption in states that have adopted a definition of investors specifically for the purpose of Rule 504(b)(1)(iii).⁶ To accomplish this result, the Commission could simply amend Rule 504(b)(1)(iii) to read as follows:

(iii) Exclusively in one or more states that define by statute, rule, order or regulation a class of investors to whom sales may be made pursuant to § 230.504(b)(1)(iii).

c. There are significant benefits to preserving Rule 504 Public Offerings. There are two significant benefits to this approach. First, preservation of Rule 504 Public Offerings is consonant with the principles of federalism. Second, preservation of Rule 504 Public Offerings will avoid the unintended consequences of imposing limitations on general solicitation and resales that are discussed below.

(i) Preserving Rule 504 Public Offerings is consonant with the principles of federalism. The proposed approach would be in accord with the principles of federalism.⁷ The limitation on the aggregate offering price in a Rule 504 Public Offering means that these offerings will be primarily local in nature and not likely to affect the national securities markets. Accordingly, the need for uniform national standards is less compelling and is outweighed by the states' interest in determining whether such offerings should be permitted and if so, the class of investors to whom securities may be sold. Indeed, in adopting amendments to Rule 504 in 1999, the Commission repeatedly emphasized the size and local nature of Rule 504 offerings.⁸ If this approach were adopted, a state would not be able to require qualification with respect to offers and sales to "qualified purchasers" but it could prevent a Rule 504 Public Offering from being effected in its jurisdiction. If a state wishes to permit Rule 504 Public Offerings, it could adopt a definition of a class of purchasers to whom sales may be made pursuant to Rule 504(b)(1)(iii). States may choose to impose higher or lower standards for such investors.⁹ In this limited area of small offerings that are more local than national, the federal government should not tell the states that they cannot tailor investor protection standards to suit their local circumstances. The benefits associated with the "laboratory of the states" will thereby be preserved and the price of experimentation will not be too high.¹⁰ However, for the reasons set forth below, I strongly believe that states should, if this approach is adopted by the Commission, take action to permit Rule 504 Public Offerings.¹¹

(ii) There would be a number of adverse, unintended consequences to issuers and investors if Rule 504 Public Offerings are not retained . Registration under the 1933 Act and qualification under state securities laws impose substantial costs on prospective issuers. In small offerings, these costs are likely to represent a greater percentage of the anticipated gross offering proceeds than larger offerings. In other words, there can be certain economies of scale associated with larger offerings. Recognizing the inefficiency of small, registered offerings, many issuers rely upon exemptions from registration and qualification. Historically, the most heavily used exemptions are for so-called private placements.¹² There have been several unintended consequences to the emphasis on private placement exemptions. These include:

Prohibiting general solicitation and advertising adversely impacts minority and women owned businesses. It is a condition to Rules 505 and 506 that neither the issuer nor anyone acting on its behalf shall offer or sale the securities by any form of general solicitation or general advertising.¹³ Similarly, California's limited offering exemption prohibits the publication of any advertisement.Cal. Corp. Code § 25102(f)(4). These restrictions give an advantage to the well connected issuer because there is no need to engage in a general solicitation if the issuer already has ready access to prospective investors. Minority and women owned businesses that are not part of the "old boys' club" may not enjoy these advantages and therefore face greater obstacles in obtaining capital. The ability to engage in a general solicitation under Rule 504 can put minority and women owned businesses on a more equal footing with companies that may be better connected to possible sources of capital.
Prohibiting general solicitation and advertising encourages the use of unregistered finders. Issuers which do not have preexisting relationships with prospective investors are likely to utilize the services of a finder. For a fee, finders will make their contacts available to issuers. In other words, "if you don't know them, buy them". In many instances, however, finders are not registered as brokers. The use of unregistered brokers or finders is more likely in a small offering since registered brokers are likely to find that it is uneconomical for them to act as underwriters or placement agents in small offerings. This is yet another example in which small businesses are at a disadvantage to larger businesses in the capital formation process. While the use of an unregistered finder may be permissible in limited circumstances, it presents a variety of risks to the issuer.¹⁴ If it is subsequently determined that the finder should have been registered, the issuer may be subject to regulatory action and the purchasers may have a right of rescission.¹⁵ The ability to engage in a general solicitation under Rule 504 reduces the incentive for issuers to use unregistered finders by making it possible for such issuers to solicit investors directly.
Prohibiting general solicitations and advertising puts small businesses at a bargaining disadvantage vis-à-vis accredited investors. Although federal and state securities laws are focused on investor protection, small businesses often lack both sophistication and bargaining position in dealing with accredited investors that by definition must be wealthy or sophisticated. For example, many small businesses receive funding from venture capital companies that are professional investors with substantially greater net worths. A small business that is prohibited from engaging in a general solicitation is necessarily limited in its ability to establish a competitive buyers market. Thus, they can be faced with "take it or leave it" situations in which they have no legal method of finding alternative buyers. One effect of prohibitions on general solicitation is to foster monopsony conditions for issuers.
Prohibiting general solicitations and advertising increases investor risk by limiting public exposure of information to the market. The federal securities laws are premised on a disclosure philosophy.¹⁶ It is therefore ironic that the prohibition on general solicitation works is at complete odds with this fundamental principle. Rather than encouraging disclosure, it discourages it.
Requirements of a preexisting relationship encourage affinity fraud. Although Regulation D does not explicitly require that investors have a preexisting relationship with the issuer, the staff of the Commission has considered the existence of such a relationship as a significant factor in determining whether a general solicitation has occurred.¹⁷ This requirement therefore encourage offers and sales to persons known to the issuer. Unfortunately, this may have the unintended consequence of directing sales to persons who may be more trusting because of their relationship to the issuer.¹⁸ Indeed, persons are likely to be less trusting of persons they don't know than those they do.¹⁹ The ability to engage in a general solicitation may actually reduce risk to all investors by making the offering subject to more extensive examination by the market.
Limitations on resales increase risk to investors by concentrating risk and limiting liquidity. Except for securities offered and sold in Rule 504 Public Offerings, the issuers must exercise reasonable care to assure that the purchasers are not underwriters within the meaning of the 1933 Act.²⁰ Thus, these securities have the status of securities acquired in a transaction under Section 4(2) of the 1933 Act and cannot be resold without registration under the 1933 Act or an exemption from registration.²¹ Restrictions on resales ultimately increase investor risk by requiring at a minimum an inefficient after-market. From the issuer's perspective, this can be expected to result in higher costs of capital because investors will discount the price of securities in consequence of the lack of liquidity.²² Permitting resales may therefore both reduce the cost of capital and investor risk.²³
Limitations on resales discriminate against small businesses. As noted above, securities that are not offered and sold in a Rule 504 Public Offering are "restricted securities" under Rule 144. While Rule 144 has a minimum of one year holding period, securities held for one year must still be sold pursuant to the other conditions of Rule 144, including the requirement that there be available adequate public information.²⁴ Because small businesses may not be able to satisfy this condition, stockholders who are non-affiliates must hold an additional year if they wish to resell their shares in reliance on Rule 144.²⁵ Thus, small businesses face a disadvantage vis-à-vis larger companies.

For the foregoing reasons, the Commission should eschew the "one size fits all approach" that is inherent in the Commission's second alternative of creating a uniform federal exemption that substantially replicates the current state exemptions. If the Commission decides to adopt such an approach, there should be no limitations on the extent to which a general solicitation may be used.

3. The definition of "qualified purchaser" should exclude purchasers in transactions exempt from registration under the 1933 Act pursuant to
Section 3(a)(11) of the 1933 Act.

There is very little legislative history regarding Section 3(a)(11) of the 1933 Act which exempts any security which is part of an issue offered and sold only to persons resident within a single state or territory when the issuer is a person resident and doing business within or, if a corporation, incorporated by and doing business within such state or territory.²⁶ However, two fundamental policy decisions necessarily inhere in Section 3(a)(11):

Congress intended that such offerings not be subject to federal registration requirements; and
The decision to impose registration or qualification requirements on such offerings was to remain at the state level.²⁷

The Commission's proposal would leave intact the first of these policy decisions. Issuers could continue to offer and sell securities within a single jurisdiction in reliance upon Section 3(a)(11). However, the Commission's proposal would eliminate state authority to require registration or qualification of offers and sales to qualified purchasers. While the NSMIA represents Congress' attempt to address the very real and substantial problems associated with costly, inconsistent, redundant and ultimately ineffective state and federal regulation of securities, the act was focused on the national securities market. Indeed, this is evidenced by the very title of the act, the National Securities Market Improvements Act. The NSMIA, therefore, does not necessarily represent a Congressional effort to eliminate local regulation of local offerings.

Because I believe that state merit review hurts investors and issuers (and small issuers in particular), it is tempting to concur in the Commission's proposal to preempt such requirements with respect to transactions exempt under Section 3(a)(11).²⁸ However, because Section 3(a)(11) by its very terms encompasses only local offerings, principles of federalism require that the Commission not preempt state authority to require registration of such offerings. In the case of local offerings, states should be able to "continue to strike their own balances and thus continue to make their own individualized rules respecting the offer and sale of securities within their own borders".²⁹

4. The qualified purchaser definition should be the same as that of an accredited investor.

Implicit in the Commission's definition of "accredited investor" are the notions that sophisticated or wealthy investors can (a) afford to absorb the risk of investment; (b) afford to bargain for information and assurances of veracity and completeness; (c) afford to purchase intermediation; or (d) possess sufficient sophistication to price properly the security being offered. Accredited investors are presumably also in a better position to negotiate amongst themselves to share costs and thereby avoid free riders. They may also be in a better position to obtain the "right" amount of information by appointing a lead investor who avoids redundant production of information by the issuer.³⁰ For all of these reasons, offers and sales to accredited investors are, subject to certain conditions, exempted from the registration requirements of the 1933 Act.

Presumably, these notions would be equally applicable to the decision by the Commission to preempt state registration requirements as well. Because the definition of "accredited investor" is well understood by securities professionals, the Commission should not establish a different definition absent further analysis and study. Should the Commission consider other definitions of "qualified purchaser", the Commission's decision should be based upon a thorough analysis of how federal and state registration requirements benefit and burden the formation of capital.

5. Conclusion.

The Commission's attention has been appropriately and understandably focused on our national securities markets. As a consequence, many of the Commission's regulatory approaches have unintentionally, but adversely affected small businesses and investors in small businesses. Furthermore, many of these approaches have disadvantaged small businesses vis-à-vis big business. It is therefore incumbent upon the Commission that it consider carefully the impact of preempting state qualification requirements through the definition of a "qualified purchaser". In particular, the Commission should not eliminate the ability of small businesses to engage in public offerings that are exempt from registration under the 1933 Act.

Very truly yours,

/s/ Keith Paul Bishop

Keith Paul Bishop

Footnotes

¹ As a result of the testimony received at the hearing, Senators Gramm, Dodd, Boxer, Faircloth, Hagel and Moseley-Braun and seven other Senators introduced S. 1260, the Securities Litigation Uniform Standards Act of 1997. Senate Banking Committee Report No. 105-182 (May 4, 1998). In 1998, Congress enacted the Securities Litigation Uniform Standards Act, Pub. L. No. 105-353, 112 Stat. 3227 (Nov. 3, 1998).
² Consonant with these principles, as Commissioner of Corporations, I drafted AB 721 (Firestone), 1997 Cal. Stat. ch. 391 which brought California's Corporate Securities Law of 1968, Cal. Corp. Code §§ 25000 et seq., into conformity with the NSMIA. For these same reasons, I supported in my testimony to the Subcommittee on Securities the reaffirmation by Congress of the Section 3(a)(10) exemption under the 1933 Act. See Written statement of Hon. Keith Paul Bishop, Commissioner, California Department of Corporations, submitted to the Senate Committee on Banking, Housing and Urban Affairs' Subcommittee on Securities "Oversight Hearing on the Private Securities Litigation Reform Act of 1995," Serial No. 105-182, at 3 (July 27, 1998).
³ 17 C.F.R. § 230.503(b)(1).
⁴ Pennsylvania, for example, has adopted such an exemption. Pa. Stat. Ann. tit. 70, § 1-203(t).
⁵ A state exemption from qualification for offers and sales to accredited investors would not have any legal effect if the state's qualification requirement for offers and sales to accredited investors is preempted.
⁶ By amending Rule 504(b)(1)(iii) to eliminate the reference to state law exemptions, the Commission avoids the problem created by federal preemption of state qualification requirements with respect to qualified purchasers.
⁷ "Federalism is rooted in the belief that issues that are not national in scope or significance are most appropriately addressed by the level of government closest to the people." Executive Order No. 13132¶2(a)(Aug., 41999). Although the Commission as an independent regulatory agency (as defined in 44 U.S.C. § 3502)) is not subject to Executive Order No. 131321, it should voluntarily apply the criteria and requirements of the order.
⁸ Securities Act Release No. 7644 (Feb. 25, 1999).
⁹ For example, a particular state may wish to impose not only net worth or income requirements for investors but also a limitation on the percentage of the investor's net worth that may be invested in an offering.
10 "To stay experimentation in things social and economic is a grave responsibility. Denial of the right to experiment may be fraught with serious consequences to the Nation. It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of the country." New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting). "The nature of our constitutional system encourages a health diversity in the public policies adopted by the people of the several States according to their own conditions, needs, and desires. In the search for enlightened public policy, individual States and communities are free to experiment with a variety of approaches to public issues. One-size-fits-all approaches to public policy problems can inhibit the creation of effective solutions to these problems." Executive Order 13132 ¶ 2(f).
¹¹ Last year in California, Assemblymember John Campbell introduced a bill, AB 1644, to permit Rule 504 Public Offerings. While I believe that state imposed limitations on general solicitation and resales suffer from the same unintended consequences engendered by similar federal limitations discussed in this comment letter, the states should continue to have the right to make policy judgments in this regard, even if the result is that some states will continue to reach conclusions that are in my view incorrect. Indeed, I believe that merit review in California harms investors and issuers alike and should be replaced. As Commissioner of Corporations, I drafted and unsuccessfully supported the adoption of The Capital Formation and Securities Fraud Enforcement Act of 1996, AB 2465 (Goldsmith). See Therese Maynard, Commentary: The Future of California's Blue Sky Law 30 Loy. L. Rev. 1573 (1997) and Staff Briefing Paper, Capital Flows and Leaky Buckets: Regulation of Securities in California, Joint Hearing of the Senate Finance, Investment and International Trade and Assembly Banking and Finance Committees (October 26, 1996).
¹² Under the 1933 Act, the statutory exemption is Section 4(2), 15 U.S.C. § 77d(1). The Commission has adopted Rule 506, 17 C.F.R. § 230.506, which deems offers and sales in satisfaction of the conditions of that rule to be transactions not involving a public offering within the meaning of Section 4(2) of the 1933 Act. In California, the principal limited offering exemption is Corporations Code Section 25102(f).
¹³ 17 C.F.R. § 230.502(c).
¹⁴ The staff of the Commission's Division of Market Regulation have indicated that in certain circumstances it will not recommend enforcement if a finder does not register as a broker under the Securities Exchange Act of 1934, 15 U.S.C. §§ 78a et seq. (the "1934 Act"). See, e.g., Paul Anka (July 24, 1991). For a general discussion of the "finders exception", see John Polanin, Jr., The Finder's Exception from Federal Broker-Dealer Registration, 40 Cath. U. L. Rev. 787 (1991).
¹⁵ Recently, several issuers have included a risk factor concerning possible rescission rights arising under Section 29 of the 1934 Act, 15 U.S.C. §78cc. See, e.g., registration statement on form S-3 filed by Microware Systems Corp. on May 17, 2001. As a practical matter, the existence of such a right may not be of much value. If the per share value implied by the new investors is higher than the per share price payable upon rescission, the investors holding the right would not exercise the rescission right. However, the existence of a right of rescission might cause new investors to discount the purchase price because the right gives its holders an opportunity, not shared by the new investors, to cash out should the stock value subsequently decline. If the per share price implied by the new investors is lower, then it is unlikely that new investors would invest only to see a portion of its proceeds used to cash out existing investors. In any event, it is unclear what policy goal is achieved by redistributing wealth from the new investors to prior round investors because a third party failed to comply with a licensing requirement.
¹⁶ Justice Louis Brandeis emphasized the beneficial effects of disclosure in his seminal work, other people's money: "Sunlight is said to be the best of disinfectants; electric light the most efficient policeman." However, there is a giant step from acknowledging the benefits of disclosure to concluding that mandatory disclosure is beneficial. See Frank Easterbrook and Daniel Fischel, The Economic Structure of Corporate Law 288 (1991).
¹⁷ See, e.g., Mineral Lands Research and Marketing Corp. (Nov. 3, 1985) ("The types of relationships with offerees that may be important in establishing that a general solicitation has not taken place are those that would enable the issuer (or a person acting on its behalf) to be aware of the financial circumstances or sophistication of the persons with whom the relationship exists or that otherwise are of some substance and duration.").
18 The Commission itself has made this point, stating: "These scams [affinity fraud] exploit the trust and friendship that exist in groups of people who have something in common." Commission Investor Alert, Affinity Fraud: How to Avoid Investment Scams that Target Groups. In a 1999 press release, the California Department of Corporations made this same point: "In affinity frauds, members of ethnic, religious and professional groups are targeted by individuals claiming to be members or friends of those groups, relying on the fact that many people tend to trust those who claim to be like themselves and to want to help them get a piece of the American dream." (emphasis added).
¹⁹ Inherent in the requirement of a preexisting relationship seems to be the perverse policy preference that if you are going to engage in securities fraud, society somehow prefers that you defraud friends, relatives and business associates rather than strangers. Ironically, this peculiar preference in favor of affinity fraud is reinforced by the fact that it may well be easier to defraud those whom you know than those whom you don't know.
²⁰ 17 C.F.R. § 230.502(d). Satisfaction of the limitation on resales set forth in Rule 502(d), 17 C.F.R. § 230.502(d) is also a condition to the exemptions set forth in Rule 505, 17 C.F.R. § 230.505, and Rule 506, 17 C.F.R. § 230.506.
²¹ 17 C.F.R. § 230.502(d). In addition, preliminary note 4 to Regulation D provides that the rules are only available to the issuer and not to any affiliate of the issuer or to any other person for resales of the issuer itself. If resales are not registered, which is an expensive proposition, they may be resold in reliance on Rule 144, 17 C.F.R. § 230.144. However, Rule 144 as a general rule provides for a minimum of one-year holding period. Rule 144(d)(1). 17 C.F.R. § 230.144(d)(1).
²² In adopting the 1999 amendments to Rule 504, the Commission recognized that limitations on resale result in liquidity discounts: "The amendments will preserve an avenue for small businesses to issue freely tradable securities and not suffer deep liquidity discounts . . ." . Securities Act Release No. 7644 (Feb. 25, 1999) (emphasis added).
²³ In adopting the 1999 amendments to Rule 504, the Commission cited "disturbing developments in the secondary markets for some securities initially issued under Rule 504". Securities Act Release No. 7644 (Feb. 25, 1999). To the extent that abuses occur in the secondary market, the Commission has ample enforcement authority through its regulation of brokers. Addressing these abuses by eliminating Rule 504 Public Offerings therefore is misplaced. It seems akin to prohibiting homeowners from selling their homes because there have been instances of misconduct by real estate brokers.
²⁴ Rule 144(c), 17 C.F.R. § 230.144(c)(1).
²⁵ Under Rule 144(k), 17 C.F.R. § 230.144(k) the requirements of paragraphs (c) (current public information), (e) (limitation on amount of securities sold), (f) (manner of sale), and (h) (notice of proposed sale) terminate as to securities sold for the account of a person who is not an affiliate of the issuer at the time of the sale and who has not been an affiliate during the preceding three months provided that the securities have been held for at least two years.
²⁶ 15 U.S.C. § 15c(a)(11). For a discussion of the legislative history to Section 3(a)(11), see Louis Loss & Joel Seligman, 2 Securities Regulation 1295 (3^rded. 1999).
²⁷ This is not necessarily to say that Congress intended that states impose registration or qualification requirements. Rather, only that Congress did not override the states' authority to make decision on whether such requirements should be imposed.
²⁸ See note 11 supra. The ineffectiveness of merit review to protect investors is illustrated by the fact that over the years many fraudulent offerings have been qualified in California, including those by ZZZZ Best and American Continental.
²⁹ Rutheford Campbell, Jr., The Insidious Remnants of State Rules Respecting Capital Formation, 78 Wash. U. L.Q. 407, 434 (2000).
³⁰ Implicit in these statements is the assumption that most offerings to accredited investors are subject to certain practical constraints on the number of investors. This should make the transactional costs associated with organizing investors lower than a broad-based public offering which assumes that intermediaries such as underwriters and securities professionals will perform these functions.

¹	As a result of the testimony received at the hearing, Senators Gramm, Dodd, Boxer, Faircloth, Hagel and Moseley-Braun and seven other Senators introduced S. 1260, the Securities Litigation Uniform Standards Act of 1997. Senate Banking Committee Report No. 105-182 (May 4, 1998). In 1998, Congress enacted the Securities Litigation Uniform Standards Act, Pub. L. No. 105-353, 112 Stat. 3227 (Nov. 3, 1998).
²	Consonant with these principles, as Commissioner of Corporations, I drafted AB 721 (Firestone), 1997 Cal. Stat. ch. 391 which brought California's Corporate Securities Law of 1968, Cal. Corp. Code §§ 25000 et seq., into conformity with the NSMIA. For these same reasons, I supported in my testimony to the Subcommittee on Securities the reaffirmation by Congress of the Section 3(a)(10) exemption under the 1933 Act. See Written statement of Hon. Keith Paul Bishop, Commissioner, California Department of Corporations, submitted to the Senate Committee on Banking, Housing and Urban Affairs' Subcommittee on Securities "Oversight Hearing on the Private Securities Litigation Reform Act of 1995," Serial No. 105-182, at 3 (July 27, 1998).
³	17 C.F.R. § 230.503(b)(1).
⁴	Pennsylvania, for example, has adopted such an exemption. Pa. Stat. Ann. tit. 70, § 1-203(t).
⁵	A state exemption from qualification for offers and sales to accredited investors would not have any legal effect if the state's qualification requirement for offers and sales to accredited investors is preempted.
⁶	By amending Rule 504(b)(1)(iii) to eliminate the reference to state law exemptions, the Commission avoids the problem created by federal preemption of state qualification requirements with respect to qualified purchasers.
⁷	"Federalism is rooted in the belief that issues that are not national in scope or significance are most appropriately addressed by the level of government closest to the people." Executive Order No. 13132¶2(a)(Aug., 41999). Although the Commission as an independent regulatory agency (as defined in 44 U.S.C. § 3502)) is not subject to Executive Order No. 131321, it should voluntarily apply the criteria and requirements of the order.
⁸	Securities Act Release No. 7644 (Feb. 25, 1999).
⁹	For example, a particular state may wish to impose not only net worth or income requirements for investors but also a limitation on the percentage of the investor's net worth that may be invested in an offering. 10 "To stay experimentation in things social and economic is a grave responsibility. Denial of the right to experiment may be fraught with serious consequences to the Nation. It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of the country." New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting). "The nature of our constitutional system encourages a health diversity in the public policies adopted by the people of the several States according to their own conditions, needs, and desires. In the search for enlightened public policy, individual States and communities are free to experiment with a variety of approaches to public issues. One-size-fits-all approaches to public policy problems can inhibit the creation of effective solutions to these problems." Executive Order 13132 ¶ 2(f).
¹¹	Last year in California, Assemblymember John Campbell introduced a bill, AB 1644, to permit Rule 504 Public Offerings. While I believe that state imposed limitations on general solicitation and resales suffer from the same unintended consequences engendered by similar federal limitations discussed in this comment letter, the states should continue to have the right to make policy judgments in this regard, even if the result is that some states will continue to reach conclusions that are in my view incorrect. Indeed, I believe that merit review in California harms investors and issuers alike and should be replaced. As Commissioner of Corporations, I drafted and unsuccessfully supported the adoption of The Capital Formation and Securities Fraud Enforcement Act of 1996, AB 2465 (Goldsmith). See Therese Maynard, Commentary: The Future of California's Blue Sky Law 30 Loy. L. Rev. 1573 (1997) and Staff Briefing Paper, Capital Flows and Leaky Buckets: Regulation of Securities in California, Joint Hearing of the Senate Finance, Investment and International Trade and Assembly Banking and Finance Committees (October 26, 1996).
¹²	Under the 1933 Act, the statutory exemption is Section 4(2), 15 U.S.C. § 77d(1). The Commission has adopted Rule 506, 17 C.F.R. § 230.506, which deems offers and sales in satisfaction of the conditions of that rule to be transactions not involving a public offering within the meaning of Section 4(2) of the 1933 Act. In California, the principal limited offering exemption is Corporations Code Section 25102(f).
¹³	17 C.F.R. § 230.502(c).
¹⁴	The staff of the Commission's Division of Market Regulation have indicated that in certain circumstances it will not recommend enforcement if a finder does not register as a broker under the Securities Exchange Act of 1934, 15 U.S.C. §§ 78a et seq. (the "1934 Act"). See, e.g., Paul Anka (July 24, 1991). For a general discussion of the "finders exception", see John Polanin, Jr., The Finder's Exception from Federal Broker-Dealer Registration, 40 Cath. U. L. Rev. 787 (1991).
¹⁵	Recently, several issuers have included a risk factor concerning possible rescission rights arising under Section 29 of the 1934 Act, 15 U.S.C. §78cc. See, e.g., registration statement on form S-3 filed by Microware Systems Corp. on May 17, 2001. As a practical matter, the existence of such a right may not be of much value. If the per share value implied by the new investors is higher than the per share price payable upon rescission, the investors holding the right would not exercise the rescission right. However, the existence of a right of rescission might cause new investors to discount the purchase price because the right gives its holders an opportunity, not shared by the new investors, to cash out should the stock value subsequently decline. If the per share price implied by the new investors is lower, then it is unlikely that new investors would invest only to see a portion of its proceeds used to cash out existing investors. In any event, it is unclear what policy goal is achieved by redistributing wealth from the new investors to prior round investors because a third party failed to comply with a licensing requirement.
¹⁶	Justice Louis Brandeis emphasized the beneficial effects of disclosure in his seminal work, other people's money: "Sunlight is said to be the best of disinfectants; electric light the most efficient policeman." However, there is a giant step from acknowledging the benefits of disclosure to concluding that mandatory disclosure is beneficial. See Frank Easterbrook and Daniel Fischel, The Economic Structure of Corporate Law 288 (1991).
¹⁷	See, e.g., Mineral Lands Research and Marketing Corp. (Nov. 3, 1985) ("The types of relationships with offerees that may be important in establishing that a general solicitation has not taken place are those that would enable the issuer (or a person acting on its behalf) to be aware of the financial circumstances or sophistication of the persons with whom the relationship exists or that otherwise are of some substance and duration."). 18 The Commission itself has made this point, stating: "These scams [affinity fraud] exploit the trust and friendship that exist in groups of people who have something in common." Commission Investor Alert, Affinity Fraud: How to Avoid Investment Scams that Target Groups. In a 1999 press release, the California Department of Corporations made this same point: "In affinity frauds, members of ethnic, religious and professional groups are targeted by individuals claiming to be members or friends of those groups, relying on the fact that many people tend to trust those who claim to be like themselves and to want to help them get a piece of the American dream." (emphasis added).
¹⁹	Inherent in the requirement of a preexisting relationship seems to be the perverse policy preference that if you are going to engage in securities fraud, society somehow prefers that you defraud friends, relatives and business associates rather than strangers. Ironically, this peculiar preference in favor of affinity fraud is reinforced by the fact that it may well be easier to defraud those whom you know than those whom you don't know.
²⁰	17 C.F.R. § 230.502(d). Satisfaction of the limitation on resales set forth in Rule 502(d), 17 C.F.R. § 230.502(d) is also a condition to the exemptions set forth in Rule 505, 17 C.F.R. § 230.505, and Rule 506, 17 C.F.R. § 230.506.
²¹	17 C.F.R. § 230.502(d). In addition, preliminary note 4 to Regulation D provides that the rules are only available to the issuer and not to any affiliate of the issuer or to any other person for resales of the issuer itself. If resales are not registered, which is an expensive proposition, they may be resold in reliance on Rule 144, 17 C.F.R. § 230.144. However, Rule 144 as a general rule provides for a minimum of one-year holding period. Rule 144(d)(1). 17 C.F.R. § 230.144(d)(1).
²²	In adopting the 1999 amendments to Rule 504, the Commission recognized that limitations on resale result in liquidity discounts: "The amendments will preserve an avenue for small businesses to issue freely tradable securities and not suffer deep liquidity discounts . . ." . Securities Act Release No. 7644 (Feb. 25, 1999) (emphasis added).
²³	In adopting the 1999 amendments to Rule 504, the Commission cited "disturbing developments in the secondary markets for some securities initially issued under Rule 504". Securities Act Release No. 7644 (Feb. 25, 1999). To the extent that abuses occur in the secondary market, the Commission has ample enforcement authority through its regulation of brokers. Addressing these abuses by eliminating Rule 504 Public Offerings therefore is misplaced. It seems akin to prohibiting homeowners from selling their homes because there have been instances of misconduct by real estate brokers.
²⁴	Rule 144(c), 17 C.F.R. § 230.144(c)(1).
²⁵	Under Rule 144(k), 17 C.F.R. § 230.144(k) the requirements of paragraphs (c) (current public information), (e) (limitation on amount of securities sold), (f) (manner of sale), and (h) (notice of proposed sale) terminate as to securities sold for the account of a person who is not an affiliate of the issuer at the time of the sale and who has not been an affiliate during the preceding three months provided that the securities have been held for at least two years.
²⁶	15 U.S.C. § 15c(a)(11). For a discussion of the legislative history to Section 3(a)(11), see Louis Loss & Joel Seligman, 2 Securities Regulation 1295 (3^rded. 1999).
²⁷	This is not necessarily to say that Congress intended that states impose registration or qualification requirements. Rather, only that Congress did not override the states' authority to make decision on whether such requirements should be imposed.
²⁸	See note 11 supra. The ineffectiveness of merit review to protect investors is illustrated by the fact that over the years many fraudulent offerings have been qualified in California, including those by ZZZZ Best and American Continental.
²⁹	Rutheford Campbell, Jr., The Insidious Remnants of State Rules Respecting Capital Formation, 78 Wash. U. L.Q. 407, 434 (2000).
³⁰	Implicit in these statements is the assumption that most offerings to accredited investors are subject to certain practical constraints on the number of investors. This should make the transactional costs associated with organizing investors lower than a broad-based public offering which assumes that intermediaries such as underwriters and securities professionals will perform these functions.