Saul Ewing LLP

lawyers@saul.com
www.saul.com

March 17, 2004

Jonathan G. Katz, Esquire
Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609

Re: File No. S7-23-03; Importance of the Bona Fide Fully Hedged Exception to Capital Formation for Small Emerging Companies

Dear Mr. Katz:

Saul Ewing LLP is pleased to respectfully submit this comment letter on behalf of our client, a private U.S. equity fund whose capital market services address the critical financing needs of developing U.S. companies. Our client stresses that its ability to make equity investments in small emerging companies directly relates to its access to available and efficient hedge markets. For many years, our client has relied upon such hedge markets made possible by the regulatory structure established by NASD Rules 3370 and 11830 ("NASD Rules").

Observing that the Commission has determined now to federalize most facets of short sale regulations, our client cautions the Commission not to incorporate NASD Rules into Commission Rules in a piecemeal fashion, but rather carry over in a comprehensive and unified manner all material provisions of the NASD Rules. A piecemeal approach will give rise to certain deleterious consequences such as the destruction of the hedge markets that are essential to our client's capital formation activities relating to the small company marketplace.

A detailed explanation of our client's concerns and recommendations follows.

I. Summary of Recommendations

We observe that the Commission proposes to carry over provisions of NASD Rules 3370 and 11830 to proposed Rule 203 of Regulation SHO. We respectfully request that the Commission preserve and carry over the current well-developed exceptions to the "affirmative determination" requirements currently existing in the NASD Rules. See NASD Rule 3370(b)(2)(B) ("b2B Exceptions"). The b2B Exceptions relate to:

transactions in corporate debt securities, to transactions in security futures, as defined in Section 3(a)(55) of the Act, to bona fide market making transactions by a member in securities in which it is registered as a Nasdaq or ADF market maker, to bona fide market maker transactions in non-Nasdaq securities in which the market maker publishes a two-sided quotation in an independent quotation medium, or to transactions that result in fully hedged or arbitraged positions.

Id.

While we support the complete list of b2B Exceptions, we focus on the need to preserve the "fully hedged" exception, particularly as it relates to a short sale of a developing company's common stock fully offset by an options position ("Bona Fide Fully Hedged Exception").

II. The Capital Market for Small Emerging Companies

According to the U.S. Small Business Administration ("SBA"), small companies with fewer than 500 employees represent about 99 percent of this nation's employers, employ nearly half of the private sector work force, and are responsible for approximately two-thirds of all new jobs and more than half the gross domestic product of the United States. According to the SBA, small businesses "are the stock from which large businesses grow, the first job of many new workers, and the opportunity for their owners to achieve the American Dream."

Small emerging companies have served as the engine of growth for America's economy. Microsoft, Intel and Genetech started out as simple dreams of visionaries and entrepreneurs, but needed access to capital to fuel the growth that made them into the household names they are today. These and thousands of other companies in their early development phase had significant challenges in raising capital. Indeed, generally small emerging companies may not have access to conventional loans through banks and other commercial lending institutions and also may not be taken seriously by any investment banking firms in today's environment. Regarding the latter, many underwriters will pass on a potential primary or secondary offering of a small company's securities if it is not a certain dollar minimum, e.g., $5 - $10 million. In short, such a "small" transaction would generate insufficient underwriting fees. Moreover, even if the company could secure an interested underwriter, typically a regional firm, the time, cost and attendant risks involved in a public offering may weigh heavily against using such a funding approach.

The increasing scarcity of capital available to small companies correlates with the demise of regional investment banking firms. In bygone days, regional brokerage firms had first hand knowledge of local companies. They knew the principals, understood their business, could tour their offices and factories, and witness directly the acceptance in the marketplace of these companies' products and services. In the past, these regional firms would finance the small companies' operations, bring them public, make markets in their stock, and provide research coverage. At the right time as the small companies grew larger, the regional firms would partner with larger national brokerage firms to obtain a higher level of funding and exposure.

The macro problem for the small cap marketplace is that the regional firms have become scarcer than an endangered species. The list of bygone regional firms, to name a few, reads like a requiem.

In the East: Alex Brown & Sons in Baltimore, Butcher & Singer, and F.J. Morrisey in Philadelphia.

In the South: J.C. Bradford in Nashville, Howard Weil in New Orleans, and Rotan Mosle in Dallas.

In the Midwest: Burns Pauley in St. Louis, The Chicago Corp. in Chicago, John J. Kinnard in Minneapolis, Loewi in Milwaukee, and Prescott Ball & Turben in Cleveland.

In the West: Hambrecht & Quist, Montgomery Securities, and Robertson Stevens in San Francisco.

Sadly and alarmingly, the statistics reveal the negative impact on the capital market for small companies resulting from the losses in the ranks of regional broker-dealers. In 1995, regional brokerages were responsible for about 42 percent of all initial public offerings ("IPOs"). By 2002, that number had dramatically fallen to less than 21 percent. In this regard, using Nasdaq as a barometer for emerging companies, as recently as 20 years ago, 95 percent of IPOs were on Nasdaq, 10 years ago, the number was 85 percent, and today, the number is approximately 60 percent. As for IPO funds raised by small companies, in 1990, the average Nasdaq IPO raised $25 million. In 2003, that average zoomed to $200 million. These statistics identify a cataclysmic change signaling the disappearance of regional broker-dealers, who historically have served as the first stop for emerging companies seeking capital.

Private equity funds such as our client have stepped in to fill, in part, this massive void.

III. Private Equity Market and Funding Structure

As noted above, today, as never before, small emerging companies face formidable capital formation challenges. Access to capital at reasonable cost and timing can translate into a strategic turning point for a company. For example, a company may need funds to purchase a plant to begin producing its product coming out of R&D. Thus, the funds can transform a company from an R&D firm to an operating company, and allow it to advance forward in its strategic business plan. As an R&D company, a company may have no access to retained earnings or other capital sources upon which to propel its leap forward. Without funding, a company's business is on hold and its future in jeopardy.

Private equity funds like our client have raised funds and developed sophisticated tools, staff and resources committed to understanding, evaluating and assisting the financing needs of small companies. In a sense, they have replaced the service void left by regional brokerage firms. The bottom line is that our client is prepared to infuse critical funds into small emerging companies. A typical transaction would entail a private placement of a company's common shares to our client at a fixed price in exchange for an agreement to provide cash for such shares upon the transaction closing. As our client would receive restricted stock in the transaction, the agreement would oblige the company to take steps to register such stock following the closing. The company would disclose this financing in a variety of ways, through a Form 8-K disclosure, press release, or notice pursuant to Rule 135c under the Securities Act of 1933, or any combination thereof ("Financing Disclosure").

Upon closing, our client receives restricted stock from the company and the company receives cash for such stock in return. Our client is now at market risk because it is holding a block of the company's restricted stock. Our client may sell such stock, but only after the company registers such shares, a process that can take 3 months or longer to complete. To address this long position risk, from time to time our client , following the Financing Disclosure, will purchase put options from or through NASD registered broker-dealers. All options are written at or in the money and are exercisable typically for 30 days, but in no event longer than 90 days. If the hedge needs to be extended, the parties may close out the existing options positions and engage in new options positions that are written at or in the money, and are exercisable for no longer than 90 days. The put options hedge the risk of market price changes in the restricted shares, while leaving our client exposed to mark-to-market risk and/or risk that the issuer will be unable to timely register the restricted shares. As a practical matter, this hedging mechanism would not be available from NASD member broker-dealers if they could not in turn hedge their market risk by selling short the publicly traded common shares that underlie their short options position.

Understanding that the NASD member is hedging its options grants with a short stock position, our client limits its options purchases to avoid triggering excessive selling pressure on the underlying stock. In this regard, our client is a block shareholder whose economic interest unequivocally favors price stability and continued liquidity in the common shares. Our client does not benefit from price volatility or excessive selling pressure in the underlying publicly traded common shares.

Working through the Bona Fide Fully Hedged Exception, our client's hedge transactions with the NASD member have worked as "shock absorbers" to cushion the adverse supply impact on the price of a small company's stock, as can be caused by a shelf or secondary offering of a large block of stock coming to the market all at once. Hence, our client's private placement activities hedged by NASD member firms relying upon the Bona Fide Fully Hedged Exception, act to reduce the sudden and severe supply shocks to companies' public stock float, and eliminate potentially destabilizing impacts on companies' stock prices. In this way, small emerging companies can raise capital in a fair, orderly and responsible manner in the marketplace.

IV. Critical Reliance on the Bona Fide Fully Hedged Exception Relating to Options under NASD Rules 3370 and 11830

The ability of NASD member firms to afford a liquid option market to our client is directly attributable to the existence of the b2B Exceptions currently present in NASD Rules 3370 and 11830. In this regard, member firms rely upon the b2B Exceptions that provides, in relevant part, that "[n]o member shall effect a 'short' sale for its own account in any security unless the member or person associated with a member makes an affirmative determination that the member can borrow the securities or otherwise provide for delivery of the securities by settlement date. This requirement will not apply to . . . transactions that result in fully hedged or arbitraged positions." NASD Rule 3370(b)(2)(B) (emphasis added).

Rule 3370 provides guidelines illustrating the scope and meaning of the b2B Exceptions with examples of short securities positions being hedged by: (i) convertible securities (e.g., convertible debentures or preferred stock), (ii) long call options, and (iii) warrants and rights. An example of the Bona Fide Fully Hedged Exception relating to options provided by NASD Rule 3370 is as follows:

• With the circumstances as above 100 shares would be exempt.
   
• If the strike price was 50 a short position would not be exempt.
   
• With any strike price and the call expiring in more than 90 days any short of the common would not be exempt.

See NASD Rule 3370(b)(5)(A)(ii).

The b2B Exceptions regarding bona fide market making transactions and transactions resulting in fully hedged or arbitraged positions are also excepted from NASD Rule 11830. The latter rule imposes a mandatory close-out requirement for Nasdaq securities that have a clearing short position of 10,000 shares or more per security and that are equal to at least one-half of one percent of the company's total shares outstanding. Proposed Rule 203 incorporates many of the provisions of NASD Rule 11830. We strongly recommend that the Commission extend comparable exceptions to Rule 203, particularly as they relate to the Bona Fide Fully Hedged Exception.

V. Continued Need for a Bona Fide Fully Hedged Exception Relating to Options

We observe that without the Bona Fide Fully Hedged Exception, NASD members could not offer options liquidity to our client because NASD members would not be able to hedge their options grants with a short stock position. Here, we note here the NASD adopted the specific hedge exceptions falling under the b2B Exceptions precisely as a means to encourage the positive marketplace effects resulting from such hedge trading activities. The b2B Exceptions were carefully crafted to assure that the positive marketplace effects tipped decisively in favor of relieving the participants involved in those transactions from affirmative determination requirements.

Without the Bona Fide Fully Hedged Exception, NASD members will be unwilling to grant put options for our client's hedging needs in connection with its capital formation activities for small emerging companies. Our client underscores that without such options hedges, our client will not engage in equity purchase transactions with some small companies due to the increased risk of holding unhedged restricted stock positions. In other cases, our client may engage in an equity purchase transaction, but at a higher cost to the small company to reflect such risk. In this regard, because the negotiated equity purchase agreement provides for the sale of stock to our client at a fixed price discounted to the stock's market price at the time of the private placement, the unavailability of an options hedge will increase the discount. This simply reflects the higher risk absorbed by our client in holding an unhedged position, and constitutes a tax that is immediately passed onto and borne by the small company in the form of a higher cost of capital.

VI. Effects of Losing the Bona Fide Fully Hedged Exception Relating to Options

Evaluating our client's capital providing business and the small emerging companies it serves, and extrapolating such against the universe of private equity firms providing capital to small companies in a similar manner, we project potentially hundreds of millions of dollars of adverse impact to this marketplace that may result from the loss of this Exception and other b2B Exceptions. Failure to adopt the b2B Exceptions would dramatically increase the cost of capital to the companies that can least afford it.

Accordingly, our client implores the Commission to take quick and incisive action to restore marketplace confidence and certainty that the b2B Exceptions, particularly the Bona Fide Fully Hedged Exception as it relates to options, will continue to operate for the benefit of small U.S. issuers.

VII. Conclusion

Our nation's small emerging companies are the engines of economic growth that have created more new jobs than the Fortune 500 and generated products, services and incomes that support millions of American workers and their families. We trust that the Commission will proceed cautiously in moving forward on regulations that could disrupt the critical capital raising processes that are relied upon and used daily by many small companies. We believe that current mechanisms such as the Bona Fide Fully Hedged Exception that support small emerging companies' access to capital must be preserved as we explore and develop new access channels and sources of capital for this important segment of our national economy.

We look forward to answering any questions raised in this letter to assist the Commission in considering the efficacy of the b2B Exceptions in general and the Bona Fide Fully Hedged Exception in particular to be incorporated into Rule 203 under Regulation SHO. Please do not hesitate to call me at (215) 972-1888 if you have any questions or comments on this letter.