September 9, 1999
Attention: Mr. Jonathan G. Katz, Secretary
Re: File No. S7-30-98
Dear Mr. Katz:
Latham & Watkins is pleased to submit comments on the Aircraft Carrier proposal.1Our letter specifically focuses on the proposed repeal of the Exxon Capital2 no-action letter and its progeny and its replacement with registration on proposed Form B for sales to Qualified Institutional Buyers (QIBs). This letter is submitted by Latham & Watkins on behalf of 15 of the nation's leading investment banks.3 We have joined together because of our similar experiences in the Rule 144A marketplace and our mutual concerns about the effect of the Release on that marketplace. While we support aspects of the Release, we disagree with the proposal to repeal Exxon Capital and replace it with a registration system available only to a select group of issuers. We believe this proposal, if adopted, would substantially increase the cost of capital, without any significant increase in investor protection.
To provide an economic framework for our letter, we commissioned Charles C. Cox of Lexecon Inc.4 to study trading during the entire Rule 144A / Exxon Capital process, from the private placement through secondary trading with particular focus on secondary trading following the Exxon Capital exchange offer.5 The Cox Study shows that typically there is no retail trading after the Exxon Capital exchange offer. The study also shows that to the extent there is retail trading after the Exxon Capital exchange offer, it averages less than 0.5% of the principal amount issued and just over 1% of the aggregate trading volume.6 The study is attached hereto.
In addition to describing the study, this letter discusses:
(1) the success and importance of the current market for high yield debt;
(2) the problems that constrained growth in this market prior to Exxon Capital and the Commission's adoption of Rule 144A;
(3) why the concerns expressed in the Release and in statements by members of the Commission and its staff with respect to the current system are misplaced, including a detailed discussion of:
(4) problems inherent with the Aircraft Carrier proposal.
I. The Current Market for High Yield Debt
As a result of the Commission's actions since 1988, an efficient market for high yield debt has developed where an inefficient market previously existed. In 1988, the staff of the Division of Corporation Finance issued the Exxon Capital no-action letter. In 1990, recognizing that registration provided no meaningful benefits to institutions that were already trading among themselves in a large secondary market for privately placed securities, the Commission adopted Rule 144A7 to provide an exemption from registration under the Securities Act for resales of restricted securities to QIBs. The Rule has the dual benefit of enabling issuers to place debt offerings to institutions on a schedule that meets the issuers' needs, on the one hand, and providing necessary liquidity to institutions to trade among themselves, on the other. A subsequent Exxon Capital exchange offer permits institutions that face regulatory and other limitations on the percentage of their portfolio that may be invested in restricted securities to exchange their restricted securities for registered securities with identical terms within a few months of closing. The Rule 144A / Exxon Capital framework has replaced 4 (1½) trading and selling securityholder shelf registration.
The Rule 144A / Exxon Capital framework has created a vibrant high yield market which facilitates capital raising by entrepreneurial companies and promotes economic growth. This market is dominated by institutions and offers issuers and investors key advantages in liquidity, transparency and efficiency over traditional bank loans and private placements. As a result, this market has grown dramatically. In 1997 alone, companies issued $260.6 billion of debt and equity securities through Rule 144A offerings, of which high yield debt and preferred stock offerings represented more than $100 billion dollars.8
II. Inefficiencies and Limitations Prior to the Rule 144A / Exxon Capital Framework
Prior to the Rule 144A / Exxon Capital framework, the high yield market was limited and inefficient in comparison to the current regime. Issuers of corporate debt generally sold their securities pursuant to separate (but typically identical) purchase agreements directly to institutions. This structure developed because issuers needed to deal directly with the institutions to receive appropriate representations, non-distribution and stop-transfer agreements and other assurances that subsequent transfers of the debt securities would not constitute a distribution under the securities laws. Otherwise, the issuer could lose the exemption for the offering. This process was costly for both the issuer and the institution.
Issuers were also required to grant each buyer shelf registration rights for multi-year periods to cover resales. Extended shelf registration rights were necessary to enable institutions, such as mutual funds and insurance companies, to comply with the regulatory limitations on the amount of unregistered securities they could own.
Shelf registration for resale by selling securityholders is inferior to the Exxon Capital exchange offer for issuers because9:
Shelf registration for resales by selling securityholders is also inferior to the Exxon Capital exchange offer for institutions because Exxon Capital enables institutions to readily obtain freely tradeable securities for regulatory purposes, whereas institutions under shelf registration continue to hold restricted securities until the securities are sold off the shelf. In addition, institutions are unable to offer or sell the securities during "black out" periods or when the registration statement is not current.
The costs to an issuer of maintaining an effective shelf registration statement for a multi-year period11 and the costs to an institution of switching its securities from its "restricted basket" to its "unrestricted basket" were often prohibitive. Issuers often utilized other forms of financing in lieu of this costly alternative. The overall result was a much smaller market for institutionally placed corporate debt securities, which were sold at a significantly higher interest rate than registered debt securities of similar tenor and maturity.
An Exxon Capital exchange offer is a far more cost-effective alternative and has brought many institutions and issuers into this marketplace. It also enables institutions to purchase more securities, while still complying with applicable regulations. This makes the institutional market for high yield debt more liquid.
The proposed repeal of Exxon Capital and its progeny would have the effect of substantially diminishing the current Rule 144A market because most institutions would be unwilling to accept the costs associated with resale shelf registration,12 especially under the Aircraft Carrier proposal. The Release asserts that the repeal would encourage registration of offerings that otherwise would be made in reliance on Rule 144A.13It is unclear why registration is a desirable result because, as the Cox Study demonstrates, QIBs dominate this market and the history of the Securities Act and the related case law show that registration was not intended to protect sophisticated investors that could "fend for themselves."14Even assuming that there were benefits of registration in this context, the repeal of Exxon Capital would not encourage registration because of the associated high costs and delays. Rather, the repeal would have the unintended result of forcing issuers to exit the U.S. securities markets entirely.15
III. The Current System
The following four concerns, which can be derived from the Release and subsequent statements by members of the Commission and its staff, appear to explain the impetus behind the proposal to eliminate Exxon Capital exchange offers, despite the absence of any demonstrated harm or abuse:
We believe that these concerns are misplaced and that the proposed repeal of Exxon Capital may result in unintended adverse effects, particularly with respect to access to, and the costs of, capital.
A. Institutions as Conduits
First, the concern that institutions purchasing securities using the Rule 144A / Exxon Capital framework are acting as conduits to retail investors is not supported by the facts. Institutions are the dominant investors in the initial private placement of high yield debt securities. As required by Rule 144A, resales by the initial purchasers can only be made to QIBs. Thus, institutions continue to be the dominant investors in Rule 144A traded securities at the time of the Exxon Capital exchange offer. According to the Cox Study, Rule 144A offerings accompanied by Exxon Capital exchange offers accounted for approximately 80% and 84% of the number of issues of all high yield debt and preferred stock in 1997 and 1998, respectively.16 Trading data analyzed by the Cox Study indicates that in the pre-exchange offer period, institutional and broker/dealer trading averages 99.3% of volume.17
More importantly, institutions remain the dominant participants in the aftermarket for securities exchanged in the Exxon Capital exchange offer. According to the Cox Study, retail trading after the Exxon Capital exchange offer averages less than 0.5% of the principal amount issued and just over 1% of the aggregate trading volume.18 Moreover, while the trading data indicates that the number of customers and trades increased after the Exxon Capital exchange offer, it also indicates that (1) there is a decrease in the trading volume as a percentage of the total amount outstanding following the Exxon Capital exchange offer19and (2) the retail component remains de minimus throughout pre- and post-exchange trading.20 Accordingly, there is no evidence in the Cox Study to support the view that retail investors acquire securities issued in Exxon Capital exchange offers to any meaningful degree. The institutions that originally purchased such securities in the Rule 144A market are not acting as conduits to the retail market by means of the Exxon Capital exchange offer. This conclusion is apparent from the realities of this marketplace. Institutions do not use Exxon Capital exchange offers to resell their securities to retail investors. Rather, institutions use Exxon Capital exchange offers as an efficient means to place their restricted securities into their "unrestricted basket" for regulatory purposes.
The Release's concern that institutions are acting as conduits to the retail market appears to be a resurrection of the "presumptive underwriter" doctrine. After informally abandoning the doctrine in the 1970s, the staff of the Division of Corporation Finance formally announced the end of the "presumptive underwriter" doctrine in the American Council of Life Insurance letter, which stated that "insurance companies and similar institutions generally should not be deemed to be underwriters under Section 2(11) with regard to the purchase of large amounts of registered securities provided such securities are acquired in the ordinary course of their business from the issuer or underwriter of those securities and such purchasers have no arrangement with any person to participate in the distribution of such securities."21 Given the Commission's goal in the Release to "modernize and clarify" the current regulatory structure, reopening the presumptive underwriter doctrine in the absence of demonstrated abuse does not appear to achieve modernization, nor is it necessary for investor protection.
The limited number of retail investors trading in the secondary market after the Exxon Capital exchange offer has the same quantum of publicly available information as purchasers in the aftermarket for initial public offerings in the equity markets. Information is available through EDGAR, and the provisions of Rule 174 under the Securities Act apply just as with other registered offerings. Moreover, these retail investors benefit from the sophistication of QIBs which, because of their dominance of the market, largely determine the trading prices of the securities. Rule 144A offerings are scrutinized by the QIBs that know that, unlike in a registered offering, their securities can only be sold to other sophisticated investors before the Exxon Capital exchange offer (and, for all practical purposes, even after that). Additionally, debt securities are typically rated by credit rating agencies that assign standardized ratings, which allow investors to readily measure the securities' price and risk profile against others in its rating class or industry group.
B. Avoiding Registration
The second concern, that Exxon Capital acts as an incentive to avoid registration, fails to acknowledge that, in all practical respects, the Rule 144A / Exxon Capital framework does not differ from registration. High yield issuers prepare their disclosure documents for the Rule 144A offering in contemplation of the Exxon Capital exchange offer and, accordingly, prepare a disclosure document that generally conforms to the Commission's requirements for registered offerings. The practice of making the Rule 144A offering memoranda conform in all material respects with the requirements for a prospectus included in a registration statement on Form S-1 is driven by (1) the demands from the QIBs to have all material information, (2) the reputation of the initial purchasers (often investment banks) which typically act as market makers after the Rule 144A offering and (3) liability concerns.22
Rather than a scheme to avoid registration, the Rule 144A / Exxon Capital framework represents an efficient system that provides full disclosure which benefits both issuers and institutions in a cost-effective manner.23 The Rule 144A / Exxon Capital framework also brings non-reporting companies and foreign issuers into the registration and reporting regime, thereby enhancing investor protection overall by making more information about more companies publicly available. In addition, indentures for debt securities generally require issuers in Rule 144A offerings to become and remain Exchange Act reporting companies, even if the Exchange Act does not require them to do so.
C. Timing of Registration
The third concern, that Exxon Capital does not make intuitive sense because it results in registration at the time of the exchange offer, rather than at the time of the original issuance of the securities, places the timing of the registration process above all other concerns, including efficiency of the market and investor protection. The concern that registration should occur at the time of original issuance presumes that under the Rule 144A / Exxon Capital framework the disclosure requirements of registration have not been satisfied. As discussed above, issuers prepare their Rule 144A offering memoranda in a manner that generally complies with the registration statement requirements of the Securities Act. Furthermore, the investors in these offerings are sophisticated institutions that determine for themselves whether they have been provided with sufficient information to make an investment decision. These institutions have the ability to ask for additional information if they believe it is necessary, and the nature of the capital formation process readily ensures that the requests of such institutions will be met. Because the QIBs are already receiving full disclosure by virtue of their buying and bargaining power, just as the Commission anticipated would occur when Rule 144A was adopted, these institutions do not need the protections of registration under the Securities Act. Thus, the timing of registration is not relevant. Moreover, any putative issue with respect to the timing of registration would be outweighed by the benefits that the Rule 144A / Exxon Capital framework provides.
There is also a related concern that the Exxon Capital exchange offer protects the QIBs that receive registered securities in the exchange offer, but not the investors that purchase securities subsequent to the Exxon Capital exchange offer because these investors do not receive a prospectus prior to their purchase. We believe that this concern is flawed because investors that purchase securities in the secondary market following a registered public offering (even under the Aircraft Carrier proposal) do not receive a prospectus prior to their purchase.24 Purchasers following a registered public offering and purchasers following an Exxon Capital exchange offer only obtain full disclosure from the issuer's registration statement which is publicly available on EDGAR.
D. Registration for Institutions
A final concern appears to be that even if securities that are sold privately under Rule 144A and exchanged in an Exxon Capital exchange offer are held only by institutions, the Commission has never concluded that core protections need not apply in a registered offering because institutions are the purchasers. The record does not support this position. In fact, the current Rule 144A / Exxon Capital framework, which is based on the premise that institutions are sophisticated and, therefore, do not need the protections provided by registration, is the result of decades of Commission experience in rulemaking, as well as related legislation and case law.25
The legislative history of the Securities Act demonstrates that the focus of the Securities Act was the protection of the "average investor." For example, James Landis, a principal draftsman of the House and Senate bills that became the Securities Act, stated that:
"The sale of an issue of securities to insurance companies or to a limited group of institutional investors was certainly not a matter of concern to the federal government. That bureaucracy, untrained in these matters as it was, could hardly equal these investors for sophistication..."26
1. Section 4(2)
The ability of institutions to "fend for themselves" has dominated the case law under Section 4(2) of the Securities Act, which provides an exemption from registration if the offering is not a "public offering." In Ralston Purina Co.,27 the Court stated that the availability of the Section 4(2) private offering exemption turns upon "whether the particular class of persons affected need [sic] the protection of the Securities Act." The judicial gloss on the section clarifies that an offeree's sophistication plays an important role in determining whether a transaction involves a public offering. The courts have continually emphasized the importance of the offeree's sophistication, even in construing the applicability of other sections of the Securities Act.28 The Fifth Circuit's decision in SEC v. Continental Tobacco Co.29 was interpreted by some to mean that all offerees in a private placement had to be insiders of the issuer. Commissioner Hugh F. Owens responded by stating that "[I]f such an interpretation were to prevail, it could lead to such a narrowing of the exemption that even an institutional investor could not qualify. This is certainly not a conclusion which I can support; in fact, I do not believe it was intended by the Commission."30 Thus, the private placement exemption from registration is clearly intended to include institutions and is an example of the Commission's longstanding policy toward institutions.
2. Regulation D
Given the uncertainty in meeting the elements of a private placement exemption under Section 4(2), in 1974 the Commission adopted Rule 146 to provide objective standards for determining when the exemption is available.31 When Rule 146 proved to be more restrictive than Section 4(2),32 the Commission adopted Regulation D.33 Rule 506 of Regulation D, which replaced Rule 146 as a safe harbor under Section 4(2), focuses on purchasers, not offerees, and permits a private placement to "accredited investors"34 and 35 nonaccredited investors with "knowledge and experience in financial and business matters."
While Rule 506 requires disclosure to nonaccredited investors similar to that provided by a registration statement, the Rule has no specific disclosure requirement for accredited investors. Regulation D assumes that an accredited investor has the bargaining power to secure the necessary information to make an investment decision. Thus, financial sophistication or wealth alone provides a sufficient basis to assume that access to information will be provided. Rule 506 is a good example of the Commission balancing the concern for capital formation35 with the type of investor involved in an offering.
3. 4(1½) Exemption
Prior to the adoption of Rule 144A, the so-called "4 (1½) exemption" was the most popular way for institutions to transfer securities purchased in a private placement to institutions in the secondary market.36 It is still used for resales to accredited investors. It is a hybrid consisting of (a) a Section 4(1) exemption which exempts transactions by anyone other than an "issuer, underwriter or dealer" and (b) a Section 4(2) analysis to determine whether the seller is an "underwriter," i.e., whether the seller purchased the securities with a view to a distribution. If the resale transaction would meet the requirements of a private placement by an issuer under Section 4(2), which would include sales to sophisticated investors, then the reseller will not be considered an underwriter and can take advantage of the 4(1½) exemption. The Commission's acknowledgment of the validity of the 4 (1½) exemption results from "the recognition that registration of such sales would be an unnecessary burden to the holder and of little practical benefit to the purchaser."37
4. Section 4(6)
Section 4(6) of the Securities Act exempts transactions involving offers or sales by an issuer solely to accredited investors up to a maximum of $5,000,000. Section 4(6) was added to the Securities Act by the Small Business Investment Incentive Act of 1980, which was designed to help small businesses raise capital. "The rationale underlying the adoption of Section 4(6) is that financial institutions and other sophisticated investors purchasing securities ... are `able to fend for themselves.' "38
5. No-Action Letters
The Black Box and Squadron Ellenoff no-action letters39 confirmed that a private placement to QIBs and/or a limited number of institutional accredited investors would not be integrated with a subsequent initial public offering. Black Box, Inc. stated in its request for no-action that if "the nature of the...purchasers is such that they are capable of fending for themselves and do not need the protections afforded by registration under the Securities Act, then no purpose is served by integrating the offering to such purchasers with the registered offering."40
In the Pacific Mutual Life Insurance Company no-action letter,41the staff confirmed that it would not recommend enforcement action to the Commission in connection with the presentation in the sales literature of certain life insurance companies of hypothetical rates of return in excess of the current recognized maximum rate generally permitted by the NASD and the Commission's staff. The no-action position was based on the representation that the data would only be presented to qualified institutional investors.42 In the incoming letter, the insurance companies submitted that "the SEC and NASD staffs have implemented a restriction on using rates of return that exceed the recognized maximum rate because...such a rate has the potential to mislead the general public," "...qualified institutional investors do not require this type of protection otherwise intended for the general public" and "...this type of investor is sufficiently sophisticated so that it does not require the protection of a regulatory position under which a certain rate of return is deemed to be per se misleading."43
6. Rule 144A and Exxon Capital
As the culmination of this legislative, rulemaking and judicial experience, in 1990 the Commission adopted Rule 144A to achieve a more liquid and efficient institutional resale market for unregistered securities.44"As the Commission determined in adopting Rule 144A, larger institutional investors, or QIBs as denominated in the Rule, are presumed to be sophisticated securities investors. Their investing experience and size purportedly puts them in a position to insist on as much information as would be provided by registration. Also their size, which may be viewed as signifying buying and bargaining power, should allow them to demand from issuers protective covenants and restrictions. In other words, their sophistication enables them to fend for themselves."45 Similarly, the Exxon Capital no-action letter was based on the premise that the securities exchanged in reliance on those letters would trade predominately among institutions. Although decades of experience have led to what is today the thriving Rule 144A / Exxon Capital framework, the Release is proposing the repeal of Exxon Capital, which will, in turn, severely impair the Rule 144A marketplace. This proposal is being made in the absence of any demonstrated harm or abuse with respect to investor protection.
It is difficult to fathom an unsophisticated investor with $100.0 million in securities under management. The QIB threshold is far greater than the accredited investor threshold under Regulation D. Furthermore, as we discussed in Section III.B above, institutions are already being provided with full disclosure under the Rule 144A / Exxon Capital framework, substantially equivalent to that provided in a registration statement. QIBs are given access to far more information than Rule 144A requires. In fact, many comment letters in response to the proposal of Rule 144A opposed the "disclosure-on-request" requirement,46the only informational requirement in the Rule,47 which states that the issuer must provide the QIB with certain very limited disclosure upon request. These comments focused on the fact that QIBs should be able to fend for themselves. Thus, the current Rule 144A / Exxon Capital framework already provides institutions with adequate disclosure for both the initial purchase and the subsequent trading.48
IV. The Aircraft Carrier's Proposal
The Aircraft Carrier's proposal to repeal Exxon Capital and adopt Form B registration would not work as well as the current system because:
A. Limited Availability of Form B
Only "seasoned" issuers would be eligible to use Form B for sales to QIBs. According to the Cox Study, approximately 51% of the issuers currently relying on Exxon Capital exchange offers are not "seasoned" issuers.50These issuers would be required to utilize Form A, which would be subject to staff review. Review necessarily entails delay compared to the Rule 144A / Exxon Capital framework, which could result in additional costs for issuers as a result of either (a) increased interest rates for missing market windows or (b) increased costs associated with the inability to access the capital markets within the necessary time frame.51
B. "Coming to Rest" Under Form B
Even issuers that qualify for Form B would bear significant burdens because eligibility for registration on Form B would be lost retroactively if the offered securities did not "come to rest" in the hands of QIBs. In that event, the offering would violate Section 5 of the Securities Act and purchasers would have a cause of action for rescission under Section 12(a)(1) of the Securities Act. Issuers would either forego registration in favor of an alternative means of financing or adopt costly contractual protective measures not unlike those commonly used to police 4(1½) transactions. Thus, the costly and unnecessary measures Rule 144A was adopted to short-circuit would be reinstated under the Aircraft Carrier proposal, if adopted.
C. Reinstitution of the "Presumptive Underwriter" Doctrine
Although in 1983 the staff of the Division of Corporation Finance successfully ended institutions' concerns with the "presumptive underwriter doctrine,"52the adoption of the Aircraft Carrier would resurrect these concerns. A QIB deemed to be a conduit would be viewed as participating in a distribution under Section 2(11) of the Securities Act. In the absence of clarity as to their status, the institutions might forgo purchasing securities in Form B offerings rather than devoting time, effort and expense in analyzing whether they would be deemed to be an underwriter as was done prior to the American Council of Life Insurance letter.
D. Difficulties with Shelf Registration
If Form B were not available, we believe that many companies would elect to avoid the time and expense associated with staff review by raising capital elsewhere.53 This is because without Exxon Capital, registration of the restricted securities issued in private transactions could only be achieved through resales under effective resale registration statements. Resale registration under the Aircraft Carrier would be impractical because of the concerns mentioned in Section II above as well as the newly-proposed requirement that the issuer file a post-effective amendment for each resale.54
Rather than providing purchasers of privately placed securities with registration rights, companies may require these purchasers to rely on Rule 144A, 4(1½) and Rule 144 of the Securities Act55for resale of securities acquired in private placements. As a result, the cost of capital would be substantially increased because the pricing terms would include a premium. Issuers that could not afford these added costs would lose access to the securities markets entirely if there were no means of ensuring the exchange of restricted securities into unrestricted securities in a manner comparable to the Rule 144A / Exxon Capital framework. There would also be less capital available for the purchase of restricted securities because institutions would quickly reach the maximum on the amount of securities that they could hold in their restricted basket. This decrease in liquidity among QIBs would also have a negative effect on pricing.
E. Losing Non-Reporting and Foreign Issuers From the Reporting Regime
As a result of the Rule 144A / Exxon Capital framework, many companies and foreign issuers that are not otherwise required to do so file reports under the Exchange Act. Of the 447 companies that issued high yield securities in 1997 using the Rule 144A / Exxon Capital framework, 233 of the companies began as non-reporting companies and approximately 185 or 79.4% of these former non-reporting companies remain reporting companies today.56 Without Exxon Capital, many non-reporting and foreign issuers would never enter the Exchange Act reporting regime because Form B would not be available and because of the time and expense associated with: (1) Form A registration or (2) shelf registration as proposed under the Aircraft Carrier. These issuers would pursue private placements without registration rights or other options outside of the U.S. securities markets,57resulting in an overall decrease in investor protection due to a decrease in publicly available information about companies with outstanding securities. In contrast to the Aircraft Carrier proposal, not only does the Rule 144A / Exxon Capital framework encourage issuers to access the U.S. securities markets, it acts as an incentive for issuers to become Exchange Act reporting companies and it keeps these issuers in the Exchange Act reporting regime.
Furthermore, registration of the initial sale of securities (whether on Form B or otherwise) would not increase delivery of prospectuses to non-institutional investors. Institutions dominate the Rule 144A market, and as the Cox Study demonstrates, institutions remain the dominant investors in the Rule 144A market following the Exxon Capital exchange offer. Presumably, institutions would continue to account for the overwhelming majority of initial purchases under the Aircraft Carrier proposal. As we stated earlier, investors in the secondary market do not, and after the expiration of the applicable prospectus delivery requirement under the Aircraft Carrier proposal would not, receive an updated prospectus in connection with their purchases. They would only obtain full disclosure from the issuer's filings available to the public on EDGAR. Requiring high yield issuers to register the initial sale of these securities would have no impact on the information available to retail or other investors which purchase in secondary market transactions.
The Rule 144A / Exxon Capital framework is the result of decades of Commission effort to maximize the efficiency of the private placement marketplace consistent with investor protection. Today, we have a vibrant and efficient marketplace for high yield debt. Therefore, we recommend that the current system be preserved and Exxon Capital and its progeny be retained. Without Exxon Capital, many issuers would not be able to use Rule 144A because of the costs and burdens associated with resale shelf registration, especially resale shelf registration as proposed in the Release. These issuers would be forced to consider other less viable options, with all of their respective attendant costs. These options are unnecessary because the trading that occurs in the Rule 144A marketplace, even after the Exxon Capital exchange offer, is dominated by institutions which do not need the benefits of registration. Registration in this context only burdens capital formation with added costs. These costs outweigh any benefits registration could provide, given the institutional nature of the purchasers in this market. While there are a few "retail" investors in this market,58they are adequately protected by the registration statement available on EDGAR and the sophistication of QIBs and ratings agencies that scrutinize the high yield offerings.
In summary, we do not believe the current system is "broken." Therefore, we respectfully submit that regulatory change is neither necessary nor appropriate to protect investors and would, if adopted, have adverse effects on capital formation.
We are pleased to have had this opportunity to provide you with our comments on the Aircraft Carrier. If you have any questions concerning this letter, please contact either Kirk A. Davenport at (212) 906-1284 or John J. Huber at (202) 637-2242.
/s/ Latham & Watkins
Attachment: Report of Charles C. Cox
of Lexecon Inc.
cc: The Honorable Arthur Levitt
The Honorable Norman S. Johnson
The Honorable Isaac C. Hunt, Jr.
The Honorable Paul R. Carey
The Honorable Laura S. Unger
Brian J. Lane, Esq.
Richard H. Walker, Esq.
Harvey J. Goldschmid, Esq.
Anita T. Klein, Esq.
-- The Regulation of Securities Offerings, Securities Act Release No. 7606 (Nov. 3, 1998) as originally published and as amended by Securities Act Release No. 7606A (Nov. 13, 1998) are referred to together as the "Release" or the "Aircraft Carrier."
--Exxon Capital Holdings Corp., SEC No-Action Letter, 1988 SEC No-Act. Lexis 682 (May 13, 1988). The Exxon Capital no-action letter allows an issuer to sell certain securities in a private offering and shortly thereafter register an offering of substantially identical securities in exchange for the privately placed securities.
-- The alphabetical listing of investment banks participating in the economic study (discussed below) and the preparation of this comment letter are: Banc of America Securities LLC, BancBoston Robertson Stephens Inc., Bear, Stearns & Co. Inc., CIBC Oppenheimer Corporation, Chase Securities Inc., Credit Suisse First Boston Corporation, Donaldson, Lufkin & Jenrette Securities Corporation, Goldman, Sachs & Co., J.P. Morgan Securities, Inc., Lehman Brothers Inc., Merrill Lynch & Co., Morgan Stanley Dean Witter, Paine Webber Inc., Prudential Securities Incorporated and Salomon Smith Barney Inc. These 15 banks also provided all of the trading data for the Cox Study. Each of these investment banks concurs in the recommendations in this letter.
-- Charles C. Cox is the Senior Vice President of Lexecon Inc., a consulting firm that specializes in the application of economics to a variety of legal and regulatory issues. Mr. Cox served as Commissioner of the Securities and Exchange Commission from 1983 to 1989 and was Acting Chairman of the Commission in 1987. He was also Chief Economist of the Commission from 1982 to 1983. Prior to joining the Commission, Mr. Cox was a professor in the Economics Department at Ohio State University and in the College of Business at Texas A&M University. From 1990 to 1993, Mr. Cox served as Chairman of United Shareholders Association, a nonprofit, nationwide organization that advocates shareholder rights and management accountability to shareholders.
--See the Cox Study at 5 for a detailed description of the methodology that Mr. Cox used in the study.
-- Id. at 8.
-- Resale of Restricted Securities, Securities Act Release No. 6862, Exchange Act Release No. 27928, 55 FR 17933 (Apr. 30, 1990).
-- Contrast this to 1990 when the total amount of high yield debt and preferred stock issued by companies was $2.1 billion. See Exhibit A to the Cox Study. Exhibit A to the Cox Study represents only debt and preferred stock offerings, while the Release contains a preliminary estimate of the 1997 Rule 144A market for both debt and equity securities compiled by the Securities Data Company as set forth in a January 2, 1998 Wall Street Journal article. See the Release at 51, n.102, 94. The final number for both debt and equity securities compiled by the Securities Data Company in February 1998 was $260.6 billion.
-- See Section IV of this letter for a discussion of how resale shelf registration is even more impractical under the Aircraft Carrier.
-- This is especially problematic for high yield issuers that typically experience events giving rise to a need to disclose material information more frequently than investment grade issuers. Often these factors result in the shelf securities not being freely tradeable on a real time basis.
-- Practical limitations such as the need for audited financial statements of an acquired company or material corporate developments often make the shelf prospectus unavailable.
-- Salomon Smith Barney Inc.'s capital markets professionals estimate that the elimination of Exxon Capital exchange offers could cost issuers 25-50 basis points in interest rate for billions of dollars of their debt. See Salomon Smith Barney Inc. / Citibank, N.A. comment letter to the Commission regarding the Aircraft Carrier (June 30, 1999).
-- See the Release at 122.
-- SEC v. Ralston Purina Co., 346 U.S. 119 at 125 (1953).
-- See Section IV of this letter for a discussion of how the Aircraft Carrier proposal could turn many issuers away from the U.S. securities markets.
-- See the Cox Study at 5.
-- Id. at 10.
-- Id. at 8.
-- Trading volume was 39.7% before the Exxon Capital exchange offer and 16.5% after the Exxon Capital exchange offer. See the Cox Study at 10. This is consistent with the fact that unlike resale shelf registration, institutions receiving securities in an Exxon Capital exchange offer do not have to sell and then repurchase their securities to receive freely tradeable securities.
-- Trading volume of the retail component was 0.19% in the pre-exchange market and 0.22% in the post-exchange market. The trading periods analyzed for the comparisons in footnotes 19 and 20 are equal numbers of days before and after the Exxon Capital exchange offer. See the Cox Study at 10.
-- American Council of Life Insurance, 1983 SEC No-Act. LEXIS 2442 (May 10, 1983).
-- The issuer and the initial purchasers remain subject to liability pursuant to Rule 10b-5 under the Exchange Act. To that end, initial purchasers and their counsel typically perform substantially the same due diligence review of the issuer for a Rule 144A offering that they would for an offering registered with the Commission. The initial purchasers also require the same comfort letters under Statement of Accounting Standards No. 72 from the issuer's accountants and substantially the same so-called "10b-5 assurances" from issuer's counsel and their own counsel as they would in a registered offering.
-- Rule 144A offerings with Exxon Capital exchange offer registration rights are used primarily by issuers to raise capital by accessing the debt markets, not as a "stealth" way to go public. The Release states that since July 1, 1998, one-third of all initial public offerings have been Exxon Capital exchange offers. See the Release at 253. This is not a fair characterization because this number is almost exclusively debt securities, and the market does not typically view registered offerings of debt securities in the way that it views initial public offerings in the equity markets. Furthermore, debt and equity are different by nature. While debt represents a contractual right to receive interest and repayment of principle, equity represents an ownership interest in the company issuing the equity.
-- The only exception to this general rule is if the seller of such securities is deemed an underwriter. Institutions that resell their securities (if they do so at all) following an Exxon Capital exchange offer are not deemed underwriters because these institutions purchase the securities in the ordinary course of business without a view to a distribution. The American Counsel of Life Insurance letter was written in response to just this type of situation and confirmed this point. See supra n.21. Therefore, there is no prospectus delivery requirement for these institutions when they resell their securities.
-- "Congress and the Commission historically have recognized the ability of professional institutional investors to make investment decisions without the protections mandated by the registration requirements of the Securities Act." Resale of Restricted Securities; Changes to Method of Determining of Holding Period Under Rules 144 And 145, Securities Act Release No. 6806, 53 FR 44016. (Nov. 1, 1998). See the remainder of Section III of this letter for a discussion of the highlights of the relevant rulemaking, related legislation and case law.
--Landis, The Legislative History of the Securities Act of 1933, 28 Geo. Wash. L. Rev. 29, 37 (1959).
-- Supra n. 14.
-- See e.g., Value Line Fund, Inc v. Marcus, 161 F. Supp. 533 (S.D.N.Y. 1958); Garfield v. Strain, 320 F.2d 116, 119 (10th Cir. 1963); Sorrell v. SEC, 679 F.2d 1323 (9th Cir. 1982); Maldonado v. Dominguez, 137 F.3d 1, 8 (1st Cir. 1998); ACME Propane v. Tenexco, Inc., 844 F.2d 1317, 1321 (7th Cir. 1988).
-- 29 463 F.2d 137 (5th Cir. 1972).
-- Address by Commissioner Hugh F. Owens before the National Association of Securities Dealers, Inc., reprinted in 152 Sec. Reg. & L. Rep. (BNA) G-2 (May 17, 1972).
-- Notice of Adoption of Rule 146 under the Securities Act of 1933 - "Transactions by an Issuer Deemed Not to Involve any Public Offering, Securities Act Release No. 5487, 1974 WL 14643 (April 23, 1974).
-- See, e.g., Woolf v. S.D. Cohen & Co., 515 F.2d 591, 612 n.14 (5th Cir. 1975), vacated and remanded on other grounds, 426 U.S. 955 (1976).
-- Revision of Certain Exemptions from Registration for Transactions Involving Limited Offers and Sales, Securities Act Release No. 6389, 1982 WL 35662 (Mar. 8, 1982).
-- The definition of "accredited investor" includes certain banks, investment companies, employee benefit plans, broker-dealers, insurance companies, business trusts, directors or officers of the issuer and natural persons with a net worth of over $1,000,000. The number of accredited investors is of course limited by the concept of general solicitation. See Rule 501(a) under the Securities Act.
-- See the adopting release for Regulation D, supra n. 33.
-- The 4(1½) exemption is far less efficient than Rule 144A because issuers must receive contractual protective measures including initial representations and warranties, transfer restrictions, mandatory legal opinions on transfer and the like to insure that the offering will not retroactively become illegal because of a subsequent "distribution."
-- C. Porter Vaughn, A Report to the Committee on Federal Regulation of Securities from the Study Group of Section "4(1½)" of the Subcommittee on [the] 1933 Act, reprinted in The Section "4(1½)" Phenomenon: Private Resales of "Restricted" Securities, 34 Bus. Law. 1961, 1962 (1979).
-- Adoption of Interim Notice-of-Sales Form for Transactions Pursuant to Section 4(6), Securities Act Release No. 6256 at 2, 1980 WL 25728 (Nov. 7, 1980).
--Black Box, Inc., SEC No-Action Letter, 1990 SEC No-Act. LEXIS 926 (June 26, 1990); Squadron, Ellenoff, Pleasant & Lehrer, SEC No-Action Letter, 1992 SEC No-Act. LEXIS 363 (Feb. 28, 1992).
--Black Box, Inc., at 43-44.
-- Pacific Mut. Life Ins. Co., SEC No-Action Letter, 1990 WL 286907 (Aug. 31, 1990).
-- Defined in the no-action letter as any non-natural person having $100 million or more in assets. Id. at 5.
-- Id. at 13.
-- See the adopting release for Rule 144A, supra n. 7.
-- The Release at 47.
-- See Rule 144A(d)(4).
-- Other than the applicability of Rule 10b-5 liability which promotes adequate disclosure.
-- Even though retail investors are able to acquire the securities subsequent to the Exxon Capital exchange offer, they have the benefit of the publicly available registration statement, to the same extent they would after any other public offering.
-- "Seasoned" issuers for the purposes of Form B for sales to QIBs would be those with a one-year reporting history that have filed an annual report under the Exchange Act.
-- See the Cox Study at 7.
-- For example, we would expect costly bridge loan financing to increase dramatically if acquisitions could no longer be timely financed by accessing capital markets.
-- See supra n.21.
-- Many borrowers would be forced to turn away from the U.S. securities markets and raise capital through other options including: commercial bank loans (which are often not available, especially to new companies that do not have the requisite collateral to secure such loans), bridge loans followed by a post-closing registered offering, offshore financing pursuant to Regulation S and private financing without registration rights.
-- This requirement would result in either (1) underwritten secondary offerings in which all the securities are sold at a lower price in view of the volume of securities being offered at one time or, more likely, (2) institutions avoiding resale shelf registration altogether.
-- Rule 144 generally allows holders to resell restricted securities one year following the date the securities were acquired from the issuer or an affiliate of the issuer.
-- See the Cox Study at 8.
-- See supra n. 53.
-- While retail investors typically purchase certain fixed-income securities like U.S. Treasuries and municipal bonds, they are averse to high-yield securities that offer less liquidity and price transparency. See William Pesek Jr., Bonds, Those High-Brow Instruments for Investment, Slowly Become Popular with the Retail Crowd, Barron's (June 28, 1999).