February 21, 2002
Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Release No. 33-8041/Comments on the
proposed definition of "qualified purchaser"
Dear Secretary Katz:
The Ohio Division of Securities ("Division") appreciates the opportunity to comment on the proposed definition of "qualified purchaser" for purposes of section 18(b)(3) of the Securities Act of 1933 (section 18(b)(3)). While the Division supports the proposed rule's inclusion of banks, institutional investors, state or ERISA employee benefit plans, trusts, charitable organizations, private business development companies, and officers, directors and general partners as described in Rule 501(a) of Regulation D (Rule 501(a)), the Division believes the income and net worth listed for individual investors of $200,000 annually (or joint spousal incomes of $300,000) and $1,000,000 net worth does not provide sufficient protection to justify the preemption of state securities laws. The Division recommends that the Securities and Exchange Commission ("SEC") not adopt the individual income and net worth standards in Rule 501(a)(5) and (6) for purposes of defining "qualified purchaser" under section 18(b)(3).
With regard to institutional investors, the definition of "qualified purchaser" under section 18(b)(3) should include all of the institutional investors in Rule 501(a)(1)-(3) and (7) to provide uniformity at the state level for institutional investor exemptions. For example, the Division notes that sales to any of the institutional investors listed in Rule 501(a) currently are subject to a self-executing exemption under the Ohio Securities Act.1 The Division believes that directors, executive officers or general partners of issuers as described in Rule 501(a)(4) may also be defined as "qualified purchasers" without a significant impact on investor protection.
SEC Release No. 33-8041 describes individual investors with $200,000 annual income (or joint spousal income of $300,000) or $1,000,000 net worth as "financially sophisticated." However, case law under section 4(2) of the Securities Act of 1933 has not equated net worth with the sophistication necessary to evaluate the risks of a private offering.2 In fact, it appears that the definition of "accredited investor" by the individual net worth standard or income standard was adopted for simplicity and to avoid subjective determinations by issuers.3 One commentator has suggested that it is merely a sacrifice of investor protection in favor of capital formation.4
Commentators have further suggested that the income and net worth tests do not insure the necessary sophistication for investor protection.5 By including the value of an investor's residence in the $1,000,000 net worth standard of "accredited investor," an investor could be deemed an "accredited investor" able to fend for himself in a securities transaction merely by appreciation in the value of a residence. Participation in a retirement program over a number of years or an inheritance could also raise an individual to the status of an "accredited investor" with limited experience in investing. It has also been noted that based on the Consumer Price Index the actual standards of accredited investor have been reduced by inflation to $120,000 annual income and $600,000, inclusive of residence, since the adoption of Rule 501(a) in 1982.6
Compounding the problem for individual "accredited investors" is the lack of required disclosure under Rule 502. For private offerings under Rules 504, 505, and 506, a disclosure document is required only for offerings to non-accredited investors. While individual "accredited investors" have the opportunity to ask questions and receive answers from the issuer on the terms of the offering under Rule 502(b)(2)(v), this provision does not provide meaningful protection for a non-sophisticated investor regardless of income or net worth.
Diversification also becomes a risk for individual "accredited investors" who are not sophisticated.7 An "accredited investor" by either the net worth or income test may have significant expenses. There is a significant risk that a non-sophisticated, individual, "accredited investor" may hold a substantial percentage of his or her portfolio in high risk, illiquid securities. These situations may lead to financial and personal catastrophes. While securities dealers and brokers have an obligation to consider the suitability of recommendations based on the client's objectives and portfolio, there is no requirement for an issuer to make any type of suitability determination for a non-sophisticated investor provided he or she meets the tests of $200,000 annual income (or joint spousal income of $300,000) or $1,000,000 net worth. Issuers also are not obligated to inquire about a non-sophisticated individual "accredited investor's" objectives or financial circumstances, such as college funding for their children, health care or retirement expenses. With the emergence of direct offerings by issuers, including Internet offerings, there is a growing risk that non-sophisticated individual "accredited investors" will face the risk of lack of diversification in their investment portfolios.
State Securities Exemptions
State securities regulations afford additional investor protection at a limited cost to issuers. For offerings under Rules 504 and 505, state securities regulations include disqualifications for issuers with past securities law violations and generally prohibit blank check and blind pool offerings. The SEC recognized the value of state securities laws in the 1999 amendments to Rule 504, requiring either state registration with delivery of a disclosure document or compliance with the Model Accredited Investor Exemption ("MAIE") developed by the North American Securities Administrators Association, Inc. ("NASAA") for general solicitations. While the MAIE exempts sales to "accredited investors," there are the additional safeguards of a state filing and limitations on the types of general solicitations, thereby precluding boiler room operations. For direct solicitations, the MAIE requires that the issuer have a reasonable belief that the investor is an "accredited investor" prior to the solicitation. For Rule 505 offerings, the Ohio Securities Act requires only a filing of the offering document required under Rule 502 or confirmation that the offering is limited to "accredited investors" and a filing fee. The Division's review is limited to compliance with Rule 505, state dealer licensing requirements, and statutory disqualifications.
Even with Rule 506 offerings, the value of a notice filing cannot be underestimated.8 The Form D allows a state securities regulator to check enforcement databases and the Internet to determine if the issuer or promoter has been the subject of past securities law violations. The Form D also provides the state securities administrator with a list of brokers and dealers selling the issuer's securities. This allows verification of compliance with state licensing requirements. Based on the information in Form D filings and filings for Rules 504 and 505 offerings, the Division has brought a number of enforcement actions and has several pending investigations relating to prohibited general solicitations, investor suitability, unlicensed dealer activity, and fraud. In addition, a consent to service of process for filings, including notice filings, provides a significant benefit to all investors. Even accredited investors may then bring a securities related lawsuit in state where a consent has been filed. Recall as well, that this consent requirement was preserved in the National Securities Markets Improvement Act of 1996 (NSMIA).9
The practice of "self-accreditation" is greatly abused by issuers and other participants. Issuers often allow investors to check a box as to whether they are an "accredited investor" without any inquiry into the accuracy of the information provided by the investor. Often, someone other than the investor provides false information. Thus, the Division is concerned that significant sales will be made to non-accredited investors. The SEC recently identified this abuse with regard to third party providers on the Internet that were not in compliance with Regulation D and the IPONET interpretive letter.10 In this interpretive letter, the SEC stated,
We understand that some entities have engaged in practices that deviate substantially from the facts in the IPONET interpretive letter. Specifically, third-party service providers who are neither registered broker-dealers nor affiliated with registered broker-dealers have established web sites that generally invite prospective investors to qualify as accredited or sophisticated as a prelude to participation, on an access-restricted basis, in limited or private offerings transmitted on those web sites. Moreover, some non-broker-dealer web site operators are not even requiring prospective investors to complete questionnaires providing information needed to form a reasonable belief regarding their accreditation or sophistication. Instead, these web sites permit interested persons to certify themselves as accredited or sophisticated merely by checking a box.11 [Emphasis added.]
In terms of cost, the fees in Ohio for offerings under Rules 504, 505, and 506 are limited to $100.00.12 For offerings under 504 and 505, the Ohio Securities Act requires only a three page filing with a copy of documents already required under Rule 502 of Regulation D.13 Following the mandate of section 18 of the Securities Act of 1933, only the issuer's Form D is required for offerings under Rule 506.14 Clearly the limited cost of the filing fee and copies of documents already required under Regulation D is justified in terms of the information provided to state securities regulators.
For offerings under section 3(a)(11) of the Securities Act of 1933 and Rule 147, the SEC's proposed definition of "qualified purchaser" potentially creates an unlimited exemption for blank check or blind pool offerings with no regulatory oversight. As intrastate offerings have been left to state securities law regulations, there are no SEC filing requirements, dollar limitations, prohibitions on blank check or blind pool offerings, or disqualifications for past securities law violations. By defining "accredited investors" as "qualified purchasers" for intrastate offerings, the SEC's proposal preempting state regulation of intrastate offerings could allow blank check and blind pool offerings that are otherwise currently prohibited under many state securities regulations, if the offerings were limited to "accredited investors."15 The proposal also appears somewhat inconsistent with section 18(b)(4)(A) which specifically excluded intrastate offerings from being covered securities. As a consequence, the regulation of intrastate offerings should be left solely to state securities regulators.
The proposed definition of "qualified purchaser" seemingly questions the value of state merit regulation for offerings registered with the SEC. While the SEC correctly notes that it is difficult to quantify the value of state merit review, the Division notes that during the 1980's and 1990's, numerous registered offerings underwritten by Duke and Company, First Jersey Securities, D.H. Blair and Company, and other penny stock dealers failed to meet the merit guidelines under the Ohio Securities Act.16 As these offerings were not registered in Ohio, Ohio residents may have saved millions of dollars by not investing in these penny stock frauds. Division regulations requiring securities dealers to make a suitability determination upon a sale provide an additional level of protection for Ohio investors.17 Clearly, Ohio investors who avoided the penny stock scams of the 1980's and 1990's speak to the value and prudence of state review.
The proposed definition also raises the question of whether free writing should be permitted. With the proliferation of Internet frauds, prime bank scams, offshore offerings, and "self-accreditation" abuses,18 free writing should not be permitted at this time. As the SEC and NASAA noted in the "Scamsites" release, investors may rush into investment opportunities without full investigation.19 Allowing free writing may compound the problem by permitting more Internet notices without SEC or state review. It is inconsistent with section 27A of the Securities Act of 1933 and traditional disclosure principals to permit free writing.20
The Division does not believe that the proposed definition of "qualified purchaser" comports with the intended purposes underlying the Securities Act of 1933 and the general tenets of investor protection. The first step in examining the original intent must be a review of the express statutory language. The Division believes that it is most important to examine the specific language of section 18(b)(3) which reads,
Sales to Qualified Purchasers. A security is a covered security with respect to the offer or sale of the security to qualified purchasers, as defined by the Commission by rule. In prescribing such rule, the Commission may define the term "qualified purchaser" differently with respect to different categories of securities, consistent with the public interest and the protection of investors.21
"Qualified purchaser" rather than "accredited investor" was used in this provision for a purpose. The Division asserts that Congress intended state preemption to be consistent with other provisions and that it is intended where there is sufficient existing regulatory oversight such as regulation by a recognized exchange or the National Association of Securities Dealers Regulation, Inc. The Division believes that historically low enforcement initiatives or investor abuse can be a basis for preemption. The Division also believes that any issuer selling securities to "accredited investors" is not within the meaning of this provision. There would be a lack of sufficient oversight, and historically, there are records of abuse in this area.
Moreover, the securities and financial markets are in a constant state of flux. As a result, the Division believes that the purpose of this provision was to provide flexibility where no state oversight is necessary.
The language in section 18(b)(3) was enacted as part of NSMIA which contained changes for numerous exempt provisions. State review was limited in conjunction with 10 of 13 exempt classes of securities under section 3(a) of the Securities Act of 1933.22 State oversight was further limited with regard to four of six exempt transactions pursuant to section 4 of the Securities Act of 1933.23
If Congress had wished to address "accredited investor" offerings in NSMIA, it would have done so in the revision to Rule 506 by virtue of section 18(b)(4)(D). In other words, section 18(b)(4)(D) would have required a notice filing only when sales are or would be made to non-accredited investors.
Even more persuasive is the fact that section 4(6) of the Securities Act of 1933 was not included. This section specifically exempts,
Transactions involving offers or sales by an issuer solely to one or more accredited investors, if the aggregate offering price of an issue of securities offered in reliance on this paragraph does not exceed the amount allowed under Section 3(b) of this title, if there is no advertising or public solicitation in connection with the transaction by the issuer or anyone acting on the issuer's behalf, and if the issuer files such notice with the Commission as the Commission shall prescribe.
Therefore, a conclusion that state review of public offerings with no restrictions to "accredited investors" was intentionally preempted when Congress specifically avoided preempting the state review of the private offerings to accredited investors, is neither reasonable nor prudent. Sacrificing state review further fails to protect the investing public and would result in meaningless preemption of state regulation.
In conclusion, the Division would support the adoption of a definition of "qualified purchaser" for purposes of section 18(b)(3) consisting of institutional investors as defined in Rule 501(a)(1), (2), (3) and (7). The Division would further support the inclusion of directors, executive officers, or general partners as "qualified purchasers" as defined in Rule 501(a)(4). The Division recommends that the income and net worth tests for individual investors under Rule 501(a)(5) and (6) not be included in the definition of "qualified purchaser" as these standards do not insure that an investor is "financially sophisticated." As one commentator concluded:
The obligation of the law, however, is do justice to the rich as well as the poor suggests that sacrificing the accredited investor on the altar of small business capital formation is difficult to justify in any manner. The almost accidental movement is not including wealthy, but unsophisticated investors in the list of those who are the fairest game for securities sales representatives is a policy that seems to have evaded examination.24
If the SEC determines that a definition of "qualified purchaser" is necessary for individual investors, the Division recommends that the SEC adopt the NASAA proposed definition of $1,000,000 of investments or a net worth of $2,000,000. The Division would also exclude the value of the investor's residence from any net worth test for "qualified purchaser."
The Division again wishes to express its appreciation for the opportunity to provide comments on this important issue central to state regulation. Please do not hesitate to contact myself or one of the Division's Registration Attorneys if we may provide further comments or discussion.
Deborah L. Dye Joyce
Commissioner of Securities
|1||See Revised Code 1707.01(S) and 1707.03(D) and Ohio Administrative Code 1301:6-3-01(D).|
|2||Securities and Exchange Commission v. Ralston Purina Co., 346 U.S. 119 (1953); Doran v. Petroleum Management Corp., 545 F.2d 893 (5th Cir. 1977).|
|3||SEC Release No. 33-6339 (Aug. 7, 1981). Proposed Rule 506 would modify existing Rule 146 in several respects. Currently Rule 146 requires the issuer to make a subjective determination prior to making offers of securities that each offeree has such knowledge and experience in financial matters that he is capable of evaluating the merits and risks of the prospective investment or that such offeree is able to bear the economic risk of the investment. However, the Commission is proposing to incorporate the accredited investor concept into the rule. Thus, certain purchasers would be presumed to meet the purchase qualifications, thereby eliminating the need for subjective judgments by the issuer about the suitability of such purchasers.|
|4||H. Friedman, On Being Rich, Accredited and Undiversified: The Lacunae in Contemporary Securities Regulation, 47 Okla. L. Rev. 291 (1994) "It may seem odd that an agency supposedly committed to the protection of investors has created an exception whereby unsophisticated investors are encouraged to invest in mispriced securities, on the ground that they can afford to lose money. But this oddity has been embraced as a method of encouraging capital formation." Supra at 299-300.|
|5||See H. Friedman, supra and M. Steinberg, The "Accredited" Individual Investor Under SEC Regulation D; Time to Up the Ante, Securities Regulation Law Journal, Volume 29 Number 1, 93 (2001).|
|6||See M. Steinberg, supra at page 95.|
|7||See H. Friedman, supra at pages 306 to 307.|
|8||It may be possible that an applicant may rely on a Regulation D provision and not file a Form D. See SEC Release No. 33-6825. "While the filing of Form D has been retained, it will no longer be a condition to any exemption under Regulation D." As such, an applicant may rely on Regulation D, avoid the filing of a Form D, rely on the proposed qualified purchaser provision, and thus never notify any securities regulator of its activities.|
|9||Section 18(c)(2)(A) of the Securities Act of 1933.|
|10||SEC Release No. 33-7856.|
|12||See Revised Code 1707.03(W), (X) and (Y).|
|13||See Revised Code 1707.03(W), (X) and (Y).|
|14||See Revised Code 1707.03(W) and (Y).|
|15||See Securities Act of 1933 Rule 419.|
|16||See Commerce Clearing House Blue Sky Law Reporter at ¶¶45,705 to 45,719.|
|17||See Ohio Administrative Code 1301:6-3-19(A)(5).|
|18||See SEC Release No. 33-7856.|
|19||See SEC Release No. 2002-17.|
|20||Section 27A of the Securities Act of 1933 provides a safe harbor for forward-looking statements by an issuer subject to the reporting requirements of the Securities Exchange Act of 1934. It is not available for initial public offerings or direct participation investment programs. The Division notes that many offerings to "accredited investors" are not '34 Act filers. Further, the Division rarely sees appropriate cautionary language in connection with such statements.|
|21||Section 18(b)(3) of the Securities Act of 1933.|
|22|| Section 18(b)(4)(C) of the Securities Act of 1933.
(4) Exemption in Connection with Certain Exempt Offerings. A security is a covered security with respect to a transaction that is exempt from registration under this title pursuant to:. . .
|23|| Sections 18(b)(4)(A),(B), and (D) of the Securities Act of 1933.
(4) Exemption in Connection with Certain Exempt Offerings. A security is a covered security with respect to a transaction that is exempt from registration under this title pursuant to:(A) Paragraph (1) or (3) of Section 4, and the issuer of such security files reports with the Commission pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934:
|24||H. Friedman, supra at page 317.|