SULLIVAN & CROMWELL
April 29, 1997
Mr. Jonathan G. Katz, Secretary,
Securities and Exchange Commission,
450 Fifth Street, N.W.,
Washington, D.C., 20549.
Re:Proposed Amendments to Regulation S (File No. S7-8-97)
Dear Mr. Katz:
We are pleased to submit our comments on Release No. 33-7392 (the "Proposing Release") proposing and soliciting comments on certain amendments to the safe harbor provisions of Regulation S under the Securities Act.
The Proposing Release indicates that the proposed amendments to Regulation S are designed to stop certain problematic practices identified by the Commission in its July 1995 interpretive release (Release No. 33-7190) (the "Interpretive Release"). They relate primarily to placements of equity securities of U.S. issuers and of non-U.S. issuers the principal trading market for which is in the United States (collectively "covered securities").
We understand the Commission’s concern that some issuers may be engaging in the problematic practices identified in the Interpretive Release. We are concerned, however, that the measures proposed are excessively restrictive and will result in affirmative harm to U.S. and foreign issuers. This harm may be unintended, but, in our view, it is far greater than the benefits the Commissionseeks to achieve through the proposed rule changes. If adopted as proposed, the amendments would effectively preclude many legitimate offshore financing activities by U.S. and foreign issuers by classifying such activities as Category 3 offerings and imposing more draconian Category 3 procedures upon them. The proposed rules will also discourage entry of foreign issuers into the U.S. market by imposing impractical and unnecessary restrictions on offshore activities of such issuers if they enter the U.S. market.
We are also concerned that the proposed amendments to Regulation S would damage the competitive position of U.S. financial markets and financial intermediaries vis-á-vis their foreign counterparts. We are aware that foreign issuers are already concerned about perceived risks of liability upon entry into the U.S. markets. We believe the proposed amendments will heighten these concerns by imposing restrictions on activities conducted wholly outside the United States. Since reporting foreign issuers would be faced with requirements that, as discussed below, may simply be impossible to comply with, there will be strong disincentives for foreign issuers to become reporting issuers with shares listed for trading in the United States. It is not in the interests of U.S. investors, the U.S. financial markets or market participants to discourage participation by foreign issuers in the U.S. markets.
In our view, the approach taken in the Proposing Release of seeking to align treatment of offshore sales with domestic private placements belies the fundamental territorial approach of Regulation S to U.S. securities laws. A better approach to problematic practices by issuers would be to follow the approach already embodied in Regulation S and base restrictions on the extent of legitimate offshore market interest in the subject security. Thus, the rule should distinguish between true "public" and "private" offerings offshore. If an offering of equity securities having a U.S. public trading market is, in fact, an offshore placement with a limited number of purchasers done in circumstances in which there is clearly no foreign market for the class of securities, it is to be expected that the securities will flow back into the United States. In a broader underwritten offering offshore, however, this should not be the case.
We would suggest a two-pronged analysis. First, an appropriate test should be applied to establish whether, upon completion of the offering, there will be a viable, liquid market for the class of securities offshore. This test could be based on a standard similar to the current test under Regulation S for substantial U.S. market interest. Market interest would thereby be assessed by two tests; one based on U.S. market interest before the offering (the existing test) and one based on expected offshore market interest after the offering (the proposed new test). Second, the rules should impose appropriate offering restrictions to ensure that the particular securities truly come to rest abroad, i.e.,that the economic risk of the investment has truly been absorbed by the offshore purchasers.
With respect to determining whether securities have come to rest abroad, we think that imposition of a restricted period provides the most workable bright line test. However, as stated in our comment letter on Release No. 33-7391 relating to proposed amendments to Rule 144, in today’s volatile markets, two-year holding periods are excessively long to ensure that the investor has absorbed the economic risk of the purchase. Extension of the holding period for securities of U.S. reporting issuers from 40 days to six months could be appropriate in cases where there is no evidence of legitimate offshore market interest, in tandem with other procedures reasonably designed to discourage flowback (which could, if practicable, include certain, but not all, of the offering restrictions contained in the proposed rules). The one-year period currently applicable to Category 3 offerings should remain unchanged.
Our comments summarize our concerns and identify those areas where we believe the proposals may be impractical. Where possible, we have suggested alternative approaches.
2. Proposed Amendments to Rule 903
a. Definition of "Covered Securities". Foreign Issuers. A central deficiency in the proposedrules is the overbroad definition applicable to foreign issuers that would be subject to the proposed amendments to Rule 903. The proposed amendments would apply to any offering of a class of equity securities by a foreign private issuer, "[i]f more than 50 percent of all trading in such class of securities took place in, or through, the facilities of securities exchanges and inter-dealer quotation systems in the United States in the shorter of the issuer’s prior fiscal year or the period since the issuer’s incorporation." This definition focuses on whether the U.S. trading market is predominant, rather than on whether there is a legitimate offshore trading market. We believe that treatment of securities of foreign private issuers should not be changed from the existing rules. If the Commission believes that securities of foreign issuers must be subject to the proposed rules, we propose two changes to recast the definition’s focus, which are more fully discussed below. First, the U.S. trading percentage should be changed to 90% from 50%. Second, there should be an additional test that 90% of market capitalization be held in the United States.
The Commission’s definition places undue emphasis on trading activity, as opposed to market capitalization or other indicia of U.S. ownership and interest, and therefore unduly disadvantages issuers from countries with illiquid or emerging markets. For example, certain emerging market issuers (with billions of dollars in assets in their home country) may maintain American Depositary Receipt ("ADR") facilities in the United States, which, while representing only a tiny portion of the issuer’s overall capitalization, nonetheless represent substantially all of its trading market. In addition, many quality foreign issuers, especially Latin American issuers, may have far less trading activity in the home market (and fewer holders) than in the U.S. market due to the economics of the home market. For such issuers, however, the U.S. market is still significantly smaller as a percentage of capitalization than the home market. Finally, the relative proportion of trading in an issuer’s securities on each of several different markets may well fluctuate from year to year,often as a consequence of changes in the liquidity of the home market rather than as a result of any action taken by the issuer.
We believe it is inappropriate to single out emerging market issuers that have a legitimate interest in capital raising in the offshore markets. As an indication of the magnitude of the problem, we have been advised by one of our depositary bank clients that one-third of all foreign issuers whose shares trade in ADRs listed on a U.S. securities exchange or inter-dealer quotation system might meet the new definition of "covered security".
Furthermore, at a 50% U.S. trading threshold even developed market issuers may be caught in the "covered securities" definition.
Accordingly, we believe that treatment of securities of foreign private issuers should not be changed from the existing rules. If the Commission believes that securities of foreign issuers must be subject to the proposed rules, we suggest that the definition of covered securities apply only to any offering of a class of equity securities by a foreign private issuer if more than 90 percent of all trading in such class of securities took place in, or through, the facilities of securities exchanges and inter-dealer quotation systems in the United States in the shorter of the issuer’s prior fiscal year or the period since the issuer’s incorporation. At a minimum, any definition should include a reference to the overall capitalization of the foreign private issuer in addition to trading volume. We propose an additional test of market capitalization of at least 90% held within the United States.
Domestic Issuers. We do not think it is appropriate to include securities of all domestic issuers within the definition of covered securities. As noted above, any test should take into account whether the U.S. issuer has an established trading market offshore or will have such a market on completion of the offering offshore.
b. Procedural Requirements. The Proposing Release would impose a number of procedural requirements on Regulation S offerings of coveredsecurities that would be extremely problematic for many reporting U.S. and foreign private issuers. The most troubling of these relate to purchaser certifications and agreements, legending and a new requirement that an issuer refuse to register transfers of securities unless made in accordance with the registration or exemptive provisions of the Securities Act, or in accordance with Regulation S. The practical effect of these requirements would be to compel issuers of covered securities to conduct legitimate offshore offerings as if they were U.S. private placements. While this approach may be appropriate for offshore offerings that are truly private, it is clearly inappropriate for offerings that are effectively public in one or more jurisdictions outside the United States.
i. Certifications. Under the proposals, purchasers of covered securities would be required to certify that they are not U.S. persons and are not acquiring the securities for the account or benefit of a U.S. person, or that they are U.S. persons who purchased securities in a transaction that did not require registration under the Securities Act. Purchasers of covered securities would also be required to agree to resell such securities only in accordance with the registration or exemptive provisions of the Securities Act, or in accordance with Regulation S. In a proposed addition to the Category 3 purchaser agreement requirement (which currently applies only to sales of equity securities by non-reporting issuers), purchasers of Category 3 equity securities of any issuer would be required to agree not to engage in hedging transactions except in compliance with the registration or exemptive provisions of the Securities Act.
These proposals are, in our view, wholly unworkable. They would effectively force issuers of covered securities to document public offerings of such securities conducted entirely outside the United States as if they wereU.S. private placements. Otherwise, the safe harbor provided by Regulation S would not be available. As a matter of comity, it seems inappropriate for the Commission to export U.S. requirements to foreign markets in this manner, particularly in the case of foreign issuers, in the absence of a formal finding that such issuers have been engaged in a pattern of abusive practices in the U.S. market. Regardless of their activities in the United States, foreign issuers should not be prohibited from conducting offerings offshore in conformity with customary practices in the target market.
It is not customary market practice in the Euromarkets or in emerging markets (for example, Hong Kong) to require purchaser certifications. We are advised by our investment bank clients that it would be practically impossible to impose U.S. practice of this sort on these markets, especially when, as is often the case, the offering occurs without the participation of U.S. counsel or financial institutions. As it is, foreign investors participating in an entirely offshore placement strenuously resist the requirement to sign certifications not typically required by local market practice, imposing significant administrative and compliance burdens on U.S. financial institutions.
Moreover, in most non-U.S. markets, as a mechanical matter, it is simply not possible to collect certifications. For example, we understand that Euroclear and Cedel are bound by banking secrecy laws in their home jurisdictions and will not reveal the identities of holders under any circumstance.
ii. Legends. The Proposing Release would also impose legending requirements on offerings of covered securities. The legend would state that the transfer of such securities is prohibited other than in accordance with the Securities Act. The legend would also state that hedging transactions involving such securities may not be conducted except in compliance with that Act. This proposal is also impractical. Legended securities may not be admitted for trading in many jurisdictions. For example, the ListingRules and the Conditions to Listing of the London Stock Exchange provide that shares with restricted transferability may be listed only in "exceptional circumstances", and we are advised by U.K. counsel that the London Stock Exchange has never found such circumstances to exist. In addition, the imposition of legending requirements for securities of a class traded on a foreign stock exchange would in some jurisdictions require the creation of a separate line of trading on the foreign exchange. Many jurisdictions (e.g. France, Finland, Norway and Sweden) now have dematerialized shares which cannot be legended. Further, since documents of title for dematerialized shares are generally delivered after a transaction is complete and may never reach the actual investor, we are not aware of any satisfactory alternatives to legends in these circumstances. Finally, the widespread use of common depositories in connection with book-entry settlement systems (such as for Euroclear and Cedel) and placement of securities in global form mean that legends are largely ineffective in providing notice to investors or market participants.
iii. Restrictions on registration of transfers. The Proposing Release would also require an issuer of covered securities, by contract or a provision in its organizational documents, to refuse to register any transfer of securities unless made in accordance with the registration or exemptive provisions of the Securities Act, or in accordance with Regulation S. We are advised that this requirement, as proposed, would be illegal under the laws of many countries or the rules of foreign stock exchanges or quotation systems. Moreover, in light of the fact that almost all securities are held in "street" name and, in many jurisdictions, in "bearer" form, it would not be possible for the transfer agent of an issuer to policetransactions as a practical matter. Decisions as to whether to permit a transfer would also require a legal judgment, which most transfer agents (especially non-U.S. transfer agents) are not qualified to make. Also, many jurisdictions (e.g., Sweden, Norway and Finland) now utilize a central electronic share registrar system which, we are advised, would not be able to accommodate such a limitation. Effectively, the proposed rule would require that (i) the securities be certificated (regardless of local rules or practices to the contrary) and (ii) the transfer agent permit transfers only upon presentation of a transfer certification (and possibly legal opinions) to ensure compliance with the transfer restrictions.
The Proposing Release proposes a new Rule 905, which would provide that covered securities placed offshore pursuant to Regulation S are "restricted securities" within the meaning of Rule 144 under the Securities Act. In our opinion, proposed Rule 905 should not be added to Regulation S.
We believe this provision reflects an erroneous view of the relationship between Rule 144 and Regulation S. Rule 144 is a safe harbor pursuant to which securities originally sold by an issuer or an affiliate in certain exempt transactions under the Securities Act may be resold inside the United States without violation of Section 5. Regulation S, on the other hand, embodies a policy of territorial demarcation of the reach outside the United States of the registration requirements of the Securities Act. The benchmark under Regulation S should be a determination of what procedures are required to ensure that the securities "come to rest abroad". This is a separate question (and should be viewed as such) from whether sales back into the United States constitute a "distribution" subject to Section 5. To characterize securities sold in reliance on Regulation S as "restricted securities" within the meaning of the Rule 144 safe harbor is to use Regulation S as a sword rather than as a delineation of whatis beyond the jurisdiction of the registration requirements of the Securities Act and what is not.
We also believe there are substantial practical difficulties in designating securities placed offshore under Regulation S as "restricted securities". For example, how will purchasers in secondary transactions be able to tell whether the security they receive is restricted or not restricted? The only way this could be done is by requiring the restricted securities to be traded separately from securities that are not restricted. In other words, the issuer (and the foreign exchanges on which its securities are listed) would have to depart from normal trading practices in order to ensure compliance with the new rules.
Moreover, as a matter of statutory analysis, the Commission cannot, by declaring securities "restricted securities" for the purpose of the Rule 144 safe harbor, subject their sale to the registration requirements of Section 5. Such securities, even though not eligible for the Rule 144 safe harbor, can still be freely sold into the United States in transactions meeting the requirements of an applicable exemption from the registration requirements, e.g., Section 4(1).
4. Practical Effects
In light of the foregoing considerations, we believe the proposed amendments would prevent many legitimate offshore financing activities by U.S. reporting issuers. U.S. issuers engage in offshore offerings of equity securities for a number of reasons, including to broaden their investor base internationally, to use their stock as currency for foreign acquisitions and to take advantage of opportunities to raise capital more efficiently than may be possible in the United States. These transactions are quite legitimately conducted offshore and generally are not motivated by a desire to avoid the disclosure and other obligations incident to Securities Act registration. The proposed procedures are so burdensome or impractical, however, that they will effectively prevent reliance on Regulation S by all U.S. issuers for most of these transactions. We believe such a result is notwarranted. While action by the Commission to prohibit abuses of Regulation S by U.S. issuers is appropriate, it should be more carefully tailored to prevent abuses without unnecessarily hindering legitimate offshore transactions.
As an example, under the proposals, if a U.S. reporting issuer sold securities offshore, in connection with a listing in an offshore market, to broaden its investor base or in connection with an acquisition, it would be necessary to legend the securities, to obtain purchaser representations and to put in place a stop transfer order at its transfer agent. Securities subject to these restrictions would not be accepted for settlement over Euroclear and Cedel nor would they be eligible for listing on, for example, the London Stock Exchange. As a result, covered securities offered under Regulation S would be limited to settling in physical form, in the DTC book-entry settlement system or, in the case of foreign issuers, in the home country settlement system only. The requirement for obtaining purchaser representations would also reduce the attractiveness of the transaction. These features would almost certainly affect the liquidity of the shares and require that they be sold at a discount. This effectively denies the U.S. issuer free access to the international capital markets and imposes a "cost of doing business" outside the United States.
b. Effects on Foreign Private Issuers.
The proposed amendments would impose impractical and unnecessary restrictions on the offshore activities of those foreign private issuers subject to the proposed amendments. Yet, the Proposing Release acknowledges that "before 1990, offshore transactions largely involved substantial global offerings of the debt or equity securities of foreign issuers, or the debt securities of domestic issuers in the Euromarkets. Since the adoption of Regulation S, these types of offshore offerings have not resulted in widespread problematic practices." [Emphasis supplied.] In the absence of a formal finding that these foreign issuers are engaged in problematic practices, imposing these restrictions would be a serious mistake. Moreover, we do not agree that the economic incentives for indirect distributions and resales by foreign issuers are the same as for domestic issuers. Given the liquidity anddepth of the U.S. markets, domestic issuers have ready access to adequate capital. Issuers from almost every other country, on the other hand, are frequently compelled by the smaller size of their home markets to raise capital outside of their domestic markets. In addition, foreign issuers who have accessed the U.S. capital markets will also, in most instances, have a quite natural interest in offering securities in their home markets or other international markets.
In addressing the abuses by what appear to be almost exclusively domestic issuers, the proposals should not impose onerous regulatory burdens and transaction costs on foreign issuers. In particular, since the adoption of Regulation S, there has been significant growth in capital raising by emerging market issuers. As discussed above, the proposed amendments to Regulation S will unfairly limit these issuers’ access to the international capital markets and their eventual participation as reporting or exempt issuers in the U.S. market.
As an example of the problems a foreign issuer would face under the proposals, consider the case of a foreign high-tech issuer that decides to make its initial public offering in the United States on NASDAQ. This occurs with regularity, because of the international reputation of the NASDAQ market. As a consequence of the offering, the issuer’s "principal market" would be the United States, regardless of what percentage U.S. holdings were in the company’s overall capitalization. Accordingly, if the issuer subsequently sold its shares in its home market, the offering would be subject to the procedural requirements set out in the proposed rules: legended shares, purchaser certifications and stop transfer requirements. In the case of a French or Hong Kong issuer, for example, the practical issues discussed above would effectively preclude the home market offering. Further, securities subject to limitations of the sort proposed are only distinguishable in a book-entry system by identifying number. If the issuer already had shares outstanding prior to its U.S. offering, and subsequently sought to issue additional securities, it would be necessary to settle the securities under a different identifying number, resulting in market confusion and price disparities.
Finally, and quite troubling, is the fact that an issuer might be deemed to have its primary market in the United States for reasons completely outside its control- for example, as a consequence of the establishment of an unsponsored ADR facility.
5. Other Matters
a. Application of proposed amendments to debt securities. In view of the lack of evidence of problematic practices in the debt markets, application of the proposed amendments to debt securities would not be justified.
(i) Overseas Directed Offerings. With the increasing integration of the European financial markets, "single country" offerings of the sort contemplated by the rules relating to "Overseas Directed Offerings" under Regulation S are today the exception rather than the norm. Indeed, under the Financial Services Directive of the European Union (the "EU"), most offerings eligible to be sold to the public in one member state of the EU may be sold to the public in all EU member states. We recommend that the rules be amended in a manner that takes into account the increasing integration of the European market.
(ii) ADRs. Currently, Regulation S does not provide guidance as to the treatment of American depositary shares ("ADSs") representing shares of foreign issuers sold in accordance with Regulation S. [The Release adopting Regulation S refers only to the acceptance of deposits by a depositary bank of shares sold in connection with an offshore distribution. (Release No. 33-6863).] The issuance of such ADSs must either be registered or exempt from the registration requirements of the Securities Act. Regulation S, however, does not state whether the category of restrictions applicable to the ADSs should be determined by reference to the status of the depositary bank or the issuer of the underlying shares. Reference to the depositary bank wouldcreate the anomalous result that the ADSs of a Category 1 issuer with a New York bank acting as depositary bank would be subject to offering restrictions not applicable to the shares themselves. We suggest that the rules be amended to clarify that the ADSs are subject to the same category of restrictions as the underlying shares. This would be consistent with current market practice.
c. Hedging transactions; Offering discounts; Use of promissory notes. Consistent with the approach we have taken in other instances and in recognition of the diverse interests of our clients, we are not commenting on possible restrictions on hedging activities, offering discounts and the use of promissory notes as discussed in the Proposing Release.
Thank you for this opportunity to comment on the proposed amendments to Regulation S. We would be pleased to discuss further questions that the Commission may have in respect of our comments. Please direct any questions to John T. Bostelman at (212) 558-3840, Daniel Dunson at (212)558-3644, Charles F. Rechlin at (213) 955-8050, Mary C. Moynihan at (202) 956-7680 or David B. Rockwell at (011-44171-710-6575).