March 3, 1997
Comments RE: Rule 144, Reg S and Rule 430A Proposals
(File Nos. S7-7-97, S7-8-97, S7-9-97)
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
Mail Stop 6-9
450 Fifth Street, N.W.
Washington, D.C. 20549
Dear Mr. Katz:
Please treat the comments in the attached January-February 1997 issue of The Corporate Counsel as this writer's comments on the Commission's proposed amendments to Rules 144 and 145, Reg S, and Rule 430A.
Please don't hesitate to call me to amplify on any of my comments.
Jesse M. Brill
THE CORPORATE COUNSEL
Vol. XXII, No. 1 JANUARY-FEBRUARY 1997
HIGHLIGHTS & PITFALLS
SEC Adopts Shortened Rule 144 Holding Periods And Proposes:
Sweeping Rule 144 Changes, Reg S Fixes and Controversial Shelf Offering for Smaller Issuers
The New Rule 144 Holding Periods
On February 18, the Commission adopted the long-awaited amendments to Rule 144 shortening the two-year holding period for sales of restricted securities to one year and reducing the three-year Rule 144(k) complete cutoff to two years. (See Release No. 33-7390, February 20, 1997, www.sec.gov/rules/final/33-7390.txt.) The effective date of the Rule changes will be April 29 (60 days after publication in the Federal Register). Until then, the Staff has made it clear that the two and three-year holding periods will remain in effect.
Commencing April 29, any restricted securities which at that time have been held at least one year may be sold under Rule 144 (even though acquired prior to the adoption of the rule change); likewise, restricted securities held at least two years will no longer be subject to any resale restrictions.
Comparable Changes Made in Gift, Pledge and Trust Contexts
At the same time, the two-year aggregation requirement for securities gifted, pledged, or transferred to trusts was changed to a one-year requirement. Thus, for example, sales by a donee will continue to be subject to aggregation with the donor's sales within the preceding three months until the sooner of one year after the gift or the completion (with tacking) of the two-year Rule 144(k) cutoff. [If, after one year from the gift, the two-year (k) holding period has not yet been satisfied, the charity would be subject to Rule 144 (including the amount limit, without aggregation) until the two-year (combined) 144(k) cutoff. See our November-December 1985 and September-October 1986 issues at pgs 2 and 6, respectively.]
Short Sales-A Way to Sell Now
Those who are chomping at the bit and cannot wait for April 29 should not overlook that short sales no longer toll the Rule 144 holding periods. Thus, it is possible to sell short now (for non-Section 16 insiders-see our November-December 1985 issue at pg 4) and cover the short sale on April 29. Do not forget, however, that the SEC requires a two-step: Because a sale prior to April 29 of restricted securities held less than two years cannot be effected under Rule 144, the short sale must be covered by shares purchased (e.g., on April 29) in the open market. On April 29, the restricted securities can be sold pursuant to Rule 144. You cannot short circuit the procedure by simply covering the short sale with the post-April 29 restricted (or even (k)) securities. (See our July-August 1994 issue at pg 4.)
Parallel Changes to Rule 145
At the same time, Rule 145 was amended so that former affiliates of acquired companies will only be subject to the 145(d) resale restrictions for one year (instead of two) after the merger (provided the issuer meets the current information requirements of 144(c), with a two-year cutoff for issuers that do not meet paragraph (c)).
Issuers should now revise their Rule 144 procedures, effective April 29, to permit sales after one year and to issue blanket instructions to their transfer agents to remove all 1933 Act restrictive legends after two years. In addition, issuers' Rule 145 procedures will need to be revised to reflect the shortened holding periods. (For more on blanket instructions for removing legends, and considerations impacting registration rights agreements as well as privately-held companies, see our March-April 1996 issue at pg 1.)
The New Rule 144 Proposals
What came as a surprise to many were the sweeping proposals to further revise Rule 144 set forth in a companion release (No. 33-7391, February 20, 1997, www.sec.gov/rules/proposed/33-7391.txt).
The proposed changes:
In addition to the above, this release solicits comments on other possible changes to Rule 144, including:
Our Comments on the 144 Proposals
We agree with the proposed changes to:
One "clarification" we would appreciate would be a statement acknowledging that former affiliates may rely on §4(1) to sell restricted securities which have been held two years without a three-month wait after termination of affiliate status. This will be especially important to practitioners who might otherwise now be reluctant to embrace a §4(1) position after only two years. (Even better, the three-month requirement could and should be dropped from new paragraph (g), as it has no 1933 Act statutory basis and was simply a concession to the old Enforcement Staff (i.e., Stan Sporkin) years ago. (See our May-June 1990 issue at pg 5.)
We also favor the complete elimination of the "underwriter" resale restrictions from Rule 145, which would free affiliates of acquired companies who do not become affiliates of the acquiring issuer to sell without restriction. We note that the Staff, at footnote 46 of the proposing release, in setting forth the current 145 resale scenarios, perpetuated a wrong position (at scenario (4)), stating that an affiliate of an acquired company who becomes an affiliate of the issuer can sell those securities under Rule 145(d) (i.e., without filing Form 144). In fact, an affiliate must always resell under Rule 144 (including filing Form 144), even where the shares being sold were purchased in the open market, received pursuant to a registration statement (such as an S-8), or received in a Rule 145 transaction.
The More Controversial Proposals
Manner of Sale. The proposal to drop the manner of sale requirement, thus permitting solicited sales and private sales, no doubt will draw much criticism. Private 144 sales by affiliates would no longer create a new holding period (unless restricted securities held less than one year), and the private sale of restricted securities after one year would also cleanse the restrictions (rather than result in tacking).
The Commission's stated reason here is to facilitate use of electronic bulletin boards and other developing trading mechanisms. But, the proposal goes far beyond and would eliminate the need for a broker, the "gatekeeper" that ensures compliance with Rule 144, and put issuers in a position of greater responsibility in ensuring compliance. We can see a lot of room for abuse where private transactions cleanse the restrictions. Moreover, with the advent of tacking (in 1990) and now the shorter holding periods, we don't see a crying need for reform here.
The purpose of the manner of sale requirements was to assure that special selling efforts and compensation arrangements usually associated with a distribution are not present in a Rule 144 sale. Our initial reaction is concern that elimination of the manner of sale requirements could emasculate the Rule, permitting greater selling efforts (i.e., distributions), giving insiders (especially at less seasoned, more speculative issuers) an edge over the general public, thereby undermining the integrity of the markets. We are, however, keeping an open mind and will want to think through all the ramifications of this one.
One way to avoid throwing out the baby with the bath water here would be to treat passive bulletin board transactions as brokers' transactions (but even here, if not carefully drafted, it could open the door to Internet distributions).
Even Shorter Rule 144 Holding Periods. We think the one and two-year holding periods are about right. Our concern is that a shorter holding period (such as six months) could result in indirect, unregistered public offerings using private purchasers as conduits for public capital raising (a la the Reg S abuses). In its solicitation of comments, the Commission asks whether shorter holding periods should be accompanied with a proscription against hedging activities. Our reaction is that, whatever the holding period, short sales and other hedging transactions are simply an indirect way to effect immediate sales into the market place.
Rule 144(e) Amount Limitations. We expect that the proposal to simplify the Rule 144 amount limits by eliminating the trading volume prong will draw a lot of fire because it will, in many cases, reduce the amount of stock which can be sold. An additional reason (i.e., beyond simplification) for dropping the volume prong is the NYSE's contention that NASDAQ trading volume figures essentially double the real trading volume because they include dealer interpositioning. This can be addressed by halving NASDAQ volume, or in other ways.
Possible Approaches to Hedging Transactions. The June 1995 Rule 144 proposing release solicited comment on whether the holding period tolling concept for short sales and other risk-reducing transactions (which was dropped in 1990) should be reintroduced for hedging transactions or whether risk-shifting transactions should be prohibited altogether during the holding period.
We have real difficulty accepting transactions which indirectly do what is prohibited directly. Thus, if a short sale or a private hedging transaction (e.g., with a broker counterparty) results in a sale into the public market, hasn't there been an open market sale that should be subject to the same restrictions which apply to the seller?
Moreover, isn't a purchaser from the issuer, who has reduced or shifted his/her risk (through the counterparty to public investors), simply an "underwriter" acting as a conduit for unregistered public sales? If Rule 144 is to maintain its integrity, hedging transactions for both affiliates and holders of restricted securities should be made in compliance with Rule 144. With the shortened holding periods, expecting someone to be at risk for one year is not unreasonable. And, preventing affiliates from indirectly selling more than the Rule 144 amount limit (through equity swaps, etc.), is what the Rule is all about. If affiliates need to sell additional shares (and if holders of restricted securities need to sell before completion of the one-year holding period), Form S-3 is available.
Indeed, the proposed new Preliminary Note to Rule 144 states that "a holding period before resale is needed to assure that persons who buy restricted securities in unregistered offerings have assumed the economic risk of investment and are not acting as conduits for the issuer in an unregistered public distribution."
Our Form 144 Proposal
While the Commission is considering further changes to Rule 144, one proposal (which would be consistent with several of the Commission's proposals, and would save substantially more dollars and trees) would be to retain the one-year holding period for sales of restricted securities by non-affiliates but eliminate the Form 144 filing requirement for non-affiliates, provided the brokers' transaction requirement is retained. Thus, the gatekeeper function of the broker would still be in place to ensure compliance with Rule 144, but the significant costs and delays associated with preparing a Form 144 would be eliminated.
We would retain the Form 144 filing requirement for affiliates (especially noting that Form 144 also contains an express representation that the seller is not selling based on inside information). But, we would create a combination Form 4/Form 144 (for actual sales) which would be filed at the time of sale and take the place of the wasted duplication resulting from the subsequent Form 4. Especially if the Commission adopts a presumption that a Section 16 Insider is an affiliate, the overlap here would make for significant savings. (And, those Section 16 Insiders who do not consider themselves affiliates could simply include a disclaimer of affiliate status in the "Remarks" section of the Form, as is currently the case.)
Several years ago, we were responsible for annual savings of hundreds of thousands of dollars by suggesting a way for the Staff to eliminate annual filings of S-8 registration statements. (See our November-December 1979 issue at pg 1.) Here, the annual savings, using the Commission's estimates, would be the elimination of approximately 27,000 filings per year (and the duplicate copies filed and retained for recordkeeping, etc., etc.). With the Commission's estimate of $200 (two hours) per filing, not to mention paper (trees), postage, etc., although not as large as our S-8 savings, these savings dwarf all the other savings which would result from the current proposals.
Because our proposal is less radical than those proposed in Release No. 33-7391, and could be viewed as a variation of the proposals already put forth in the Release (including the suggestion to eliminate the application of Rule 144 in its entirety to restricted securities held one year), we think the Commission could adopt our proposal without reproposing it for comment. We would urge our readers to include this suggestion in your Rule 144 comments to the SEC.
The Reg S Proposals
Also on February 18, the SEC proposed long-overdue changes to Regulation S to bring Reg S in line with Rule 144 by treating securities issued under Reg S as "restricted securities" subject to the Rule 144 one and two-year holding periods. (See Release No. 33-7392, www.sec.gov/rules/proposed/33-7392.txt.)
In addition, the Commission has also proposed imposing on Reg S transactions certification and legending requirements, prohibiting hedging transactions "unless in compliance with the 1933 Act," restricting the use of promissory notes as payment for securities, and making clear that restrictions on restricted securities cannot be cleansed through offshore resales. Consistent with the treatment of other issuances of restricted securities, Reg S sales by issuers would be reportable quarterly on Form 10-Q (or 10-K), rather than currently on Form 8-K as is now required.
In essence, under the proposal, Reg S offerings will once again (as was the case prior to 1990) be treated very much like non-public offerings, but with the only restriction on solicitation/sales being to exclude the U.S. (and U.S. persons).
What troubles us is that the SEC has waited so long to close the door on the Reg S abuses and, now that it has finally taken what is obviously the right step, instead of adopting the changes post-haste, the Commission is seeking further comments-and is unnecessarily linking the proposed changes with the proposal to amend Rule 430A (see below) and even with the further Rule 144 proposed changes. We would urge the Commission to adopt the Reg S amendments as soon as possible and without linkage.
The Rule 430A Proposals-A Back Door Primary Shelf for Unseasoned Issuers
Perhaps the most perplexing proposal (see Release No. 33-7393, February 20, 1997, www.sec.gov/rules/proposed/33-7393.txt), which Commissioner Hunt described at the SEC's February 18 meeting as "throwing a bone" to those smaller issuers that could no longer raise capital so readily under Reg S, is a proposed amendment to Rule 430A that would essentially permit most non-S-3 qualifying issuers that are current in their 1934 Act reporting for the preceding 12 months (not even requiring timely filings!) to register on the shelf equity as well as debt, by permitting the issuer to delay the pricing information and naming the underwriter (and describing the plan of distribution) for up to one year after the effective date of the registration statement (and to do so via a Rule 424(b) prospectus supplement, which is not subject to Staff review). This proposal is designed to provide small issuers with the flexibility to respond quickly and cost-effectively to favorable market windows to meet their capital needs and to reduce the need of such issuers to rely on Regulation S and private placements. [Currently, Rule 430A (which allows the pricing amendment to be filed via a 424(b) supplement after the effective date of a registration statement, and is deemed part of the registration statement as of the effective date) requires filing of the pricing amendment no later than 15 business days after the effective date, unless the offering is a shelf offering. And, under Rule 415, primary shelf offerings are not available to non-S-3 issuers (see our May-June 1995 issue at pg 7).]
To rely on this procedure, issuers would be required to deliver a prospectus (including the 424(b) supplement) to investors 48 hours prior to sale (as is currently required for IPOs), accompanied by the issuer's latest 10-Q and any current 8-Ks (unless the prospectus supplement contains the same information, which cannot be incorporated by reference). Thus, the proposed amendment would permit non-S-3 issuers to take tranches off the shelf by filing prospectus supplements containing pricing and underwriting information and other material disclosures about the tranche via Rule 424(b), without delay or Staff review. Voila!
Unless we are missing something, this seemingly minor change (delaying pricing and naming of underwriters) is in fact a back door way of, in essence, bestowing the benefits of the Wallman Advisory Committee's proposed company registration approach (through a mini-omnibus shelf registration) on companies which may be least deserving of such latitude. In effect, the same unseasoned companies that have taken advantage of Reg S to raise capital by having less reputable broker-dealers shop their stock to overseas investors by offering discounts of 15 to 20% off the current market price with only a 40-day holding period will now be able to offer their "deals" to U.S., as well as overseas investors, even offering discounts to the current market price-without a 40-day wait and without any notice to the market that these purchasers of stock off the shelf are in effect acting as underwriters, reselling stock to the public without the public purchasers receiving the benefit of the delivery of a prospectus and the protections which would result from a reputable underwriter's due diligence (even a reputable underwriter would not have sufficient time to perform adequate due diligence).
This proposal (which seems to accomplish an end run around the company registration process, that was to have evolved in measured steps and was to be accompanied by safeguards such as increased 1934 Act reporting) should be reconsidered and should not in any way be tied to the speedy adoption of the Reg S proposals.
The comment period for each of the three February 20 proposing releases ends April 29 (the same 60 days after publication in the Federal Register). Please note that comments can now be e-mailed (saving paper, postage, etc.) directly to the SEC at: firstname.lastname@example.org. One benefit of electronic filing is that comment letters will be posted on the Commission's Internet Web site (www.sec.gov).
We would urge our readers to submit your Rule 144 comments early, especially if you make reference to our Form 144 filing savings suggestion, so that the Staff and Commission have ample time to begin working on drafting and implementing the new approach.
The S-3 Universal Shelf
A funny thing happened on the way to this issue of The Corporate Counsel. We were going to cover universal shelf practice even before the Staff's unexpected Rule 430A proposal.
The universal shelf registration statement, which was born by amendments to Rule 415 and 457 and Forms S-3 and S-4 (see Rel. No. 33-6964, October 22, 1992, the same Release which reduced the S-3 primary offering requirements-see our September-October 1992 issue at pg 10), has now become commonplace, especially in today's protracted frothy, volatile market. In light of what it is, it's little wonder that issuers eligible to use it (essentially any issuer eligible to use Form S-3 for a primary offering, which these days-with a $75 million float at today's market prices-covers a lot of companies) are not excited about the company registration concept put forth by the Commission last summer.
What It Is
Release No. 33-6964 contemplates "shelf registration of debt, equity and other securities without a specific allocation of offering amounts among the classes of securities being registered." In practice today, issuers register a blanket amount (e.g., $500,000,000) of debt securities, preferred stock, depositary shares (representing fractional interests in preferred stock), common stock and common stock warrants, without any pricing information and without naming an underwriter. [A good way to spot a universal shelf offering for review, in the Commission's daily list of 1933 Act filings on the SEC Web site, is that there is only a dollar amount instead of the type of securities being registered (e.g., "common stock" or "bonds," etc.).]
The regulations creating the universal shelf have been a mystery for many of us, perhaps because of the oblique location of the implementing rule changes. Rule 457(o) was added to provide, in part: "The number of shares or units of securities need not be included in the Calculation of Registration Fee." And, corresponding new paragraph D. was added to S-3 General Instruction II (and General Instruction J. to Form S-4).
Most importantly, as announced in the adopting release, the registration statement lists the types of securities covered "and the prospectus supplement would specify the amount of the particular security to be offered," as well as the plan of distribution, the underwriter(s), pricing information and other specifics about the tranche being taken off the shelf (e.g., debt terms).
The S-3 Filing-The Base Prospectus
The first step in the universal shelf process is to file an S-3 registration statement and have it become effective (often with no review, as these are S-3 issuers). In addition to a lengthy Calculation of Registration Fee on the facing page, this filing will contain a "base" or "core" prospectus which will be largely generic, but describing each of the securities which may be offered (as required by S-K Item 202, and not allowed by Rule 430A to be deferred to the supplement). Often, the filing is made in anticipation of a future debt offering (medium term notes for REITs are a rage these days) and so the base prospectus will contain much disclosure about the structure of proposed debt, including covenants, trustee arrangements, etc. But, the details (e.g., the plan of distribution and use of proceeds), which won't be known until a tranche comes off the shelf, are left for the supplement, which is filed like any Section 424(b) prospectus supplement, i.e., without a post-effective amendment or any Staff review. In practice, this allows takedowns to occur in a matter of a few days from the time of the investment banker's go-ahead through closing!
One of the tricky parts of this process is the "filing" of exhibits at the takedown stage without triggering a post-effective amendment. The way this is done is that those exhibits which are not available when the registration statement is processed are included in the exhibit index, but are filed subsequently via Form 8-K. (See e.g., S-K Item 601(b)(23)(ii), which provides that a consent may be filed as an exhibit to material incorporated by reference.)
[Note that the typical incorporation by reference language in the prospectus is broad enough to pick up material filed in a 1934 Act report. And, those exhibits can be footnoted in the S-3 exhibit index as follows: "To be filed by amendment or as an exhibit to a document to be incorporated by reference herein in connection with an offering of the offered securities." Thus, e.g., the underwriting agreement and the form of Indenture and a supplementary legal opinion can be filed via an 8-K at the time of the takedown, when the supplement is prepared and filed. Even if a legal opinion is included with the registration statement, the Staff (and underwriter's counsel) usually wants an updated opinion at takedown.]
The estimates in Item 14 of Part II of Form S-3 should cover the entire offering, including the tranches.
A problem can arise where an issuer may be contemplating a specific offering at the time the shelf registration statement is being processed, but makes no disclosure in the registration statement. The October 1992 universal shelf adopting release mentions a 48-hour minimum rule of thumb here (i.e., between the effective date of the registration statement and (filing of) the prospectus supplement). More recently, we have heard of a seven-day rule of practice. But, the real point here is that, if an offering is in the works or "certain" (see Release No. 33-7168 at II.A.5, May 11, 1995) at the time the registration statement becomes effective, it is the Staff's position that information concerning the offering should be included in the base prospectus and the Rule 430A undertakings should be included (see below). In this context, we note that a debt takedown shortly after the effective date would be less suspect than an equity takedown.
Rule 415 Shelf Approach vs Current Rule 430A Pricing Amendment Approach
The 415 approach is utilized when there is no present intention to effect an offering (i.e., a takedown) at the time the registration is declared effective. In that situation, there would be omitted from the registration statement (and base prospectus) even more information than is allowed to be deferred under current Rule 430A. In the adopting release for Rule 430A (Rel. No. 33-6714, May 27, 1987) the Commission provided helpful practice guidance in this regard:
"[I]n order to provide additional market flexibility and to avoid an artificial election between the two rules prior to effectiveness, a registrant eligible to engage in a delayed offering pursuant to Rule 415 may retain the option to proceed under either rule as long as it includes the undertakings called for by both Items 512(a) and 512(j) of Regulation S-K. Such a registrant may choose to include both sets of undertakings (at the time of initial filing or in a pre-effective amendment) either if it plans to offer one tranche of securities immediately and the remainder on a delayed basis, or if it is uncertain at the time it files whether or not the securities will be offered on a delayed basis. At the time it requests acceleration of effectiveness, a registrant that has no present intent to make the first offering of securities under the registration statement promptly, and therefore will be making the offering on a delayed basis rather than in reliance on Rule 430A, should so state in its request for acceleration. It may then continue to omit, in addition to Rule 430A information, other information not known at the time of effectiveness. When the delayed offering is ultimately made, the prospectus containing the required information will be filed pursuant to Rule 424(b) (2) or (5)."