Testa, Hurwitz & Thibeault, LLP Attorneys at Law High Street Tower, 125 High Street Boston, Massachusetts 02110 Office (617) 248-7000 Fax (617) 248-7100 Direct Dial (617) 248-7278 E-Mail schnoor@tht.com April 28, 1997 Mr. Jonathan G. Katz Secretary Securities and Exchange Commission 450 Fifth Street, N.W. Washington, DC 20549 RE: Revision of Rule 144, Rule 145 and Form 144 - Release No. 33 7391 (File No. S7-07-97) Dear Mr. Katz: We have been retained on behalf of the National Venture Capital Association (the "NVCA") to respond to the request of the Securities and Exchange Commission ("SEC" or "Commission") in Release No. 33-7391, issued on February 20, 1997 (the "Release") for comments on proposals relating to Rule 144 ("Rule 144") and Rule 145 ("Rule 145") under the Securities Act of 1933 (the "1933 Act"). These proposals would add a bright line test to the definition of "affiliate" contained in Rule 144, eliminate the manner of sale requirements contained in Rule 144, eliminate the presumptive underwriter provisions of Rule 145 and codify certain SEC staff interpretive positions. In addition, the NVCA is offering its views in response to the SEC”s request for comment on further revisions to the holding period requirements contained in Rule 144, the elimination of the trading volume tests to determine the amount of securities that can be resold under Rule 144 and the possible regulatory approaches to hedging transactions. The NVCA is a professional association representing over 240 venture capital firms throughout the United States. Collectively, these firms account for approximately 80% of all professional venture capital financings each year. In 1996, the venture capital community invested over $10 billion in more than 1,500 financings of emerging growth companies. These venture-backed companies, primarily in the communications, computer, health services and consumer fields, are at the forefront of creating jobs, exports and tax revenues on the federal and state level. In addition, 260 venture-backed companies raised $11.8 billion in initial public offerings ("IPOs") in 1996, representing approximately 30% of all money raised by IPOs in 1996. The ability to access public market liquidity, and the terms on which such access is made available, is of critical importance for NVCA member firms. The NVCA therefore strongly supports the policy objectives of the Commission in both simplifying Rule 144 while also enhancing the process of capital formation. However, the NVCA is concerned about how certain aspects of the Proposal will affect the role of the venture capital community in the capital formation process. In particular, the definition of the term "affiliate" under Rule 144 and the potential elimination of the trading-volume leg of the volume of sale limitation under Rule 144(e) may have a significant impact on venture capital investors. I. Definition of Affiliate under Rule 144 and Rule 145. The Commission proposed in the Release to create a "safe harbor" from the definition of affiliate under Rule 144(a)(1). Under this proposal, persons who are not "insiders" under Section 16 of the Securities Exchange Act of 1934 (the "34 Act") (i.e. parties who are not executive officers, directors or 10% shareholders) would be deemed not to be affiliates under the resale provisions of Rules 144 and 145. Under proposed amendments to Rule 144(a)(1), Section 16 •insiders– would still be able to invoke a subjective facts and circumstances test to assert that they are not in a control relationship with the issuer, and therefore not affiliates under Rule 144 and 145. The NVCA welcomes the SEC”s efforts to create a bright line exclusion from the Rule 144 definition of affiliate. However, the NVCA has concerns about where the Commission proposes to draw the line, particularly with respect to persons who may be considered affiliates solely by virtue of their shareholdings. Because the degree of influence or control of any given ownership percentage is highly dependent on other facts and circumstances - in particular the pattern of holdings by other shareholders - the NVCA recognizes that drawing a bright line in this area is inherently difficult. Nonetheless, we believe that the 10% level is too low a level to presume the degree of control over the affairs of an issuer that is inherent in the notion of affiliate status. In this regard, we note that shareholder rights plans (also known as •poison pills–) - which are designed to provide procedural safeguards to encourage a prospective acquirer to negotiate with an issuer”s board of directors before the acquirer has acquired enough shares to influence or control the issuer - are generally not triggered until the acquirer owns 15% or 20% of the issuer. Accordingly, the NVCA supports the position taken by the Advisory Committee on the Capital Formation and Regulatory Processes (the "Advisory Committee") in its report to the SEC on July 24, 1996. The Advisory Committee has recommended limiting the definition of affiliate under Rule 144 and Rule 145 to the chief executive officer, insider directors, holders of 20% of the voting power and holders of 10% of the voting power with at least one director representative on the board of directors. The NVCA believes that the Advisory Committee proposal, by excluding outside directors who own less than 10% of voting power and other shareholders who own less than 20% of voting power, ties a person”s affiliate status more clearly with his, her or its ability to control the issuer (e.g., by excluding shareholders who hold less than 20% of the voting power without board representation). If the Commission chooses not to follow the proposal of the Advisory Committee, then the NVCA would strongly recommend a change to at least one aspect of the affiliate safe harbor contained in the Proposal. Specifically, the NVCA believes that the safe harbor for shareholders without board representation should be expanded to include persons who own between 10% and 20% of class of equity securities and who are eligible to report their holdings on Schedule 13G. Unlike Schedule 13D, which is designed to provide an early notification of the acquisition of securities by persons who are prospective acquirers, Schedule 13G is generally available to persons who, among other things, have acquired securities in the ordinary course of business without the purpose or effect of "changing or influencing the control of the issuer." The NVCA believes that distinguishing between Schedule 13D and Schedule 13G filers would represent a reasonable balancing in view of the difficulty of defining affiliate status in the range of ownership between 10% and 20%. Moreover, the NVCA believes that drawing a distinction on this basis will not complicate the administration of Rule 144, since beneficial owners in this range are already required to determine whether they are required to file on Schedule 13D or Schedule 13G. II. Removal of Manner of Sale Requirement. The NVCA supports the proposal by the SEC to eliminate all of the manner of sale requirements set forth in Rule 144(f). The current rule makes it impossible for a seller to solicit purchasers, use innovative methods for selling securities such as electronic bulletin boards and other electronic trading systems or to privately negotiate a sale of a Company”s stock to a purchaser without a broker, even in cases where the other Rule 144 requirements such as the holding period, public information, notice and volume limitations have been satisfied. We agree with the Commission that these manner of sale requirements currently unduly restrict transactions that are not distributive in nature and that the public information, holding period, volume and notice requirements of the Rule 144 regarding resales are adequate to determine what should constitute a distribution. With respect to the questions raised by the Commission as to the likely impact of eliminating the manner of sale requirement, the NVCA notes that there is ample evidence in the form of sales under Rule 144(k) in support of the conclusion that the manner of sale requirements are not necessary to protect the integrity of public trading markets. NVCA member firms have substantial experience, both direct (as sellers) and indirect (as distributors of restricted securities to venture capital investors who then resell the shares), with sales under Rule 144(k). Rule 144(k) sales are not required to comply with the manner of sale requirements of Rule 144(f), and therefore may be made with seller solicitation of buyers, special selling efforts, on or off of regulator security markets and with or without the participation of brokers. In spite of this broad flexibility, the NVCA believes that the substantial majority of Rule 144(k) sales flow through established securities markets involving broker and other market intermediaries, for the simple reason that these typically provide the best price and execution for sell orders. In contrast with the widely publicized problems with resales of shares issued under Regulation S, these unrestricted sales under Rule 144(k) have not given rise to widespread or systematic abuses. The NVCA believes that the favorable experience under 144(k) would carry over into other Rule 144 sales if the manner of sale requirement were to be eliminated. The NVCA further believes that the remaining requirements - public information, holding period, volume and notice requirements - provide adequate safeguards, and that issuers and affiliated sellers have both the incentive and means to enforce compliance with these requirements. III. Codification of SEC Positions Regarding Determination of Holding Period. The Commission has proposed amendments to Rule 144 to clarify and codify staff interpretive positions concerning the calculation of holding periods in circumstances involving the conversion or exchange of securities and the formation of holding companies. The NVCA supports the Commission”s proposed actions in this regard. In particular, the clarification of the treatment of conversions and exchanges are of vital interest to venture capital investors, who frequently invest in securities other than shares of common stock, which securities are then converted into or exchanged for common stock of the issuer at a later time. By integrating these well established principles into the Rule, the Commission will reduce the burden imposed on venture capital investors, who frequently must spend considerable time and resources educating newly public issuers and their counsel as to the application of Rule 144 in this area. IV. Elimination of "Presumptive Underwriter" Doctrine from Rule 145. The NVCA strongly supports the Commission”s proposal to eliminate the "presumptive underwriter" provisions under Rule 145(c), which explicitly deem persons who were affiliates of any party to a reclassification, merger or consolidation or transfer of assets to be underwriters for purposes of the 1933 Act. The presumptive underwriter doctrine can have a particularly dramatic impact on affiliates of public companies acquired in mergers; these persons often receive relatively small holdings in the acquiring company, yet may find themselves severely disadvantaged in comparison to other holders unaffiliated with the acquiring company because their sales are subject to volume limitations under Rule 145. In other words, the presumptive underwriter doctrine produces the counter intuitive result that a person who receives shares pursuant to a registration statement under the 1933 Act and who is unaffiliated with the issuer is nonetheless subject to the Rule 144 volume limitations. In many cases venture capitalists who sit on the boards of public companies that are prospective targets are torn between their duty to their venture funds - which would best be served be resigning as a director in advance of a prospective merger, thereby avoiding Rule 145 presumptive underwriter restrictions - and their duty as a director to the other shareholders of the public company - which calls for continued service in order to help guide the company through the merger. The NVCA shares the Commission”s view that it is no longer necessary to rely on a presumptive underwriter approach in connection with resale of securities acquired in Rule 145 transactions, by affiliates of the acquired company. The NVCA believes that the registration requirement under the 1933 Act, which requires the registration of shares to be issued by the acquirer on an S 4, together with the application of Rule 144 to sales by affiliates of the acquirer, provide adequate safeguards for public market investors. Accordingly, the NVCA supports elimination of the presumptive underwriter doctrine as advancing the goals of both simplification and capital formation. V. Rule 144 Holding Period. The Commission has solicited comment on whether the newly adopted Rule 144 one year holding period should be further shortened to a shorter period, such as six months. The NVCA neither supports nor opposes this further shortening, which would not, as a practical matter, have a significant impact on its members. In most cases, the underwriters of a portfolio company IPO requires that the company”s principal shareholders, including its venture capital investors, agree not to sell any shares for a period of time - generally 180 days - after the IPO. Accordingly, the benefit of a six month holding period would only extend to shares acquired with six months of the effectiveness of the IPO. Shares purchased within this period do not typically represent a significant portion of the holdings of most venture capital investors. The Commission has also solicited comment on whether the holding period for unrestricted resales by non-affiliates should be shortened from two years. The NVCA supports a further shortening of this holding period. This further shortening would enable venture capital funds to provide faster liquidity to fund investors, thereby increasing their returns and attracting more capital for investment in emerging growth companies. Moreover, the NVCA believes that the benefits to investors in venture capital funds and prospective portfolio companies would not result in any loss of protection for public market investors. The NVCA notes that, as mentioned above, underwriters in IPOs generally insist on a six-month lock-up. This is the period of time that, based on practical experience, appears to best balance the need of pre-IPO investors for liquidity with the need of public market investors for an orderly trading market. Finally, the Commission solicited comment on a number of other variations in approaches to defining holding periods. These variations include linking the holding periods to the size of the company, or varying the holding period based on the nature of the security. The NVCA opposes these variations, which will greatly increase the complexity and expense of the complying with Rule 144 and are therefore counter to the goals of simplicity and capital formation. The NVCA is particularly concerned about distinctions based on the size of companies; fluctuations in the size of emerging companies, however measured, will make advance planning difficult or even impossible. VI. Elimination of Trading Volume Test. In the Release, the Commission solicits comment on whether the two tests based on the trading volume under Rule 144(e) should be eliminated, thereby forcing all sellers of restricted and control securities to rely on the "one percent test" discussed below. Under Rule 144(e), the amount of securities that may be sold by holders of restricted and control securities within the preceding three month period is limited to the greater of (i) one percent of the Company”s outstanding securities, (ii) the average weekly trading volume in the Company”s securities or all national securities exchanges and/or reported through the automated quotation system of a registered securities association in the four full calendar weeks prior to the filing of the required notice of intent to sell or (iii) the average weekly trading volume in such securities reported through the consolidated transaction reporting system during the four week period specified in (ii) above. The NVCA strongly disagrees with the elimination of the trading volume tests under Rule 144(e)(ii) and (iii). The first reason set forth in the Release for an elimination of the trading volume tests is that if most persons selling securities under Rule 144 rely on the "one percent test" an elimination of the trading volume tests would simplify the compliance with the volume limitations under Rule 144(e). In our experience, however, most NASDAQ traded emerging growth companies, particularly higher profile companies, have weekly trading volumes in excess - often well in excess - of one percent of their outstanding common stock. Investors in these emerging growth companies, therefore, rely to a significant extent on trading volume tests in making resales under Rule 144. The NVCA is concerned that any empirical analysis of Rule 144 sales based solely on the Forms 144 filed with the Commission will greatly understate the importance of the trading volume test. In particular, any analysis that ignores the aggregation requirements under Rule 144(e)(3) will produce significantly misleading results if the analysis assumes that any person reporting the sale of less that 1% of the outstanding shares is not relying on the trading volume test. For example, assume a venture capital fund that owns 3% of an issuer”s outstanding Common Stock distributes those shares to ten limited partners, each of which has a 10% interest in the fund. Because the limited partners are required to aggregate their sales, they can only sell in reliance based on the trading volume test, even though their Forms 144 will report the sale of 0.3% of the issuer”s stock. The availability of the trading volume test is of critical importance to venture capital investors and, therefore, to the capital formation process. A rule of thumb in the venture capital business is that out of every ten portfolio investments two or three companies will result in total or substantial losses; four or five companies will move sideways, producing modest gains or losses; two or three companies will produce solid returns of three to five times cost; and one or two companies will produce superior returns of ten or more times cost. This means that the ability to realize the gains of the relatively small number of very successful investments is critical to the portfolio”s performance, since these gains must make up for the losses and produce all of the net profit. Moreover, the most successful portfolio companies often receive several rounds of investments, which means that venture capital funds often have their largest holdings in their most successful portfolio companies. The loss of the trading volume test will have a dramatic impact on the ability of venture capital funds to realize returns in their most important investments - i.e. those companies where they have the largest holdings. Accordingly, elimination of the trading volume test will discourage large investments by venture capitalists, thereby undercutting the objective of enhancing capital formation. The NVCA believes that the trading volume tests are the most appropriate measure of defining the contours of activity that would not constitute a distribution of securities under Section 2(11) of the 1933 Act. One of the characteristics of a transaction rising to the level of a distribution is its size relative to the regular ongoing trading market in the issuer”s stock. The trading volume tests, by definition, better capture the historical patterns of trading in the subject securities than the static one percent test. The Commission also solicits comments in the Release on the concerns set forth by the New York Stock Exchange ("NYSE") in its Petition for Rulemaking filed on July 9, 1996 (the "Petition"). The NYSE asserts that the trading volume test are not comparable between the NASDAQ market and the national securities exchanges because of the way trades are reported for the different markets. According to the NYSE, there is typically double counting of trading volume on NASDAQ and other dealer markets because of dealer-interpositioning. The NYSE argues that this places them at a competitive disadvantage in attracting new listings because of the perceived ability of company officials in new companies to more readily sell a greater quantity of restricted securities on NASDAQ and the other dealer markets than on the NYSE and other securities exchanges. The NVCA disagrees with the NYSE both as the dynamics of the two markets as well as the motivations of companies in selecting markets for their shares. On the first point, the alleged double-counting only occurs when a NASDAQ market maker buys, for its own account, from a seller and then turns around and later sells the shares, again from its own account, to a buyer. In many cases a market maker may simply act as a broker, matching buy and sell orders from independent parties; in these cases there is no "double counting". Moreover, the NYSE also understates the potential for double counting in its own market. NYSE trading is run by specialist firms, who have the obligation to buy and sell securities for their own account as necessary to maintain an orderly market; in these cases there will also be "double counting". NVCA member firms have had substantial experience in guiding their portfolio companies through IPOs, and the NVCA does not believe that the availability of a potentially more favorable trading volume calculation is a significant factor in choosing between NASDAQ and the NYSE. Many other factors - including the listing requirements, the ability to attract a market following and research coverage, the presence of competitors and other comparable companies - play a more important role in these decisions. In short, the NVCA does not agree that the NYSE is at any competitive disadvantage to NASDAQ and other dealer markets merely because of perceived differences in the way trades are calculated. * * * * * * * * * On behalf of the NVCA, we would like to express our thanks to the Commission for providing this opportunity to comment on the Proposal. We hope that the Commission will find these comments helpful. If you have any questions or would like further information regarding this letter, please feel free to contact me at (617) 248-7278 or Mark G. Heesen of the NVCA at (703) 351-5267. Respectfully submitted, William J. Schnoor, Jr. cc: Mr. Mark G. Heesen 347644 __________________________________________ This e-mail message is subject to attorney-client privilege and contains information intended only for the person(s) named above. If you have received this transmission in error, notify us immediately. Destroy the original message and all copies.