APPENDIX A THE IMPACT OF THE CURRENT REGULATORY SYSTEM ON INVESTOR PROTECTION AND CAPITAL FORMATION I. Introduction The Committee, in the course of its deliberations, identified costs associated with the current regulatory process and disclosure requirements relating to public offerings of securities, secondary market trading and corporate reporting. The Committee then investigated the extent to which the benefits derived from the existing regulatory structure continue to justify the identified costs. Although significant progress has been made by the Commission over time to streamline the capital formation process, particularly through the adoption of the integrated disclosure system and shelf registration, domestic capital formation through public securities offerings continues to be hampered by costs and uncertainties associated with the registration process. These costs include both direct and indirect costs created by the registration process, including costs resulting from the increasingly complex, and often ambiguous, legal distinctions that have evolved to protect that process. The current regulatory system crafted during the era of the Great Depression does not fully and most efficiently meet the needs and realities of today's markets, which are increasingly complicated by modern financing techniques, technological advancements, globalization, and changes in investor profiles and demands. These developments bring into question whether all ==========================================START OF PAGE 2====== types of companies should be subject to the current Securities Act's transactional registration requirements each time they desire to raise capital in the public markets. After concluding that the current structure was imposing unnecessary costs, while not fully taking into account the needs of today's investors, the Committee determined to recommend a shift in the focus of the regulatory structure from the current transactional system to a company registration system that would reduce these costs while enhancing investor protection. II. Direct and Indirect Costs and Uncertainties Resulting From the Registration Process for Public Offerings The current registration scheme imposes indirect and direct costs. The indirect costs include uncertainty and delay arising from the possibility of Commission staff review (including the possibility of losing a market window), market overhangs, short-selling and related activities, and publicity constraints. Direct costs include legal, accounting, underwriting, printing and filing fees. A. Costs of Registration - The Offering Process 1. Direct Costs Associated with the Public Offering Process The public offering process can be costly for issuers. For smaller companies and newer entrants to the capital markets, the fees paid to the Commission, state regulators, accountants, lawyers, underwriters, and financial printers amount to a larger percentage of offering proceeds than for more seasoned issuers. However, the absolute amount of these direct costs also can be significant for more seasoned issuers. Generally, direct costs are higher for offerings of common stock compared to bonds. From January 1990 through December 1994, it is estimated that the ==========================================START OF PAGE 3====== direct costs of raising capital in public offerings averaged 2.2% of proceeds for straight debt, 3.8% for convertible bonds, 7.1% for repeat offerings of equity by seasoned issuers, and 11.0% for initial public offerings of equity.-[1]- Table 1 below, prepared by the Committee staff, shows the breakdown of the components of the direct costs of public offerings, focusing on offerings of common stock from January 1993 to December 1995. Underwriter's compensation (spread) is the largest component of floatation costs, typically amounting to 5.3% of proceeds in repeat offerings and 7% of proceeds in initial public offerings. Systematic underpricing, as measured by the discount from market price, constitutes the second largest component, typically amounting to 1.2% of proceeds in repeat offerings and 7.1% in initial public offerings. Summing these costs and all other direct fees (for lawyers, accountants, printers, and regulators), the total cost of raising capital through public offerings of common stock typically amounts to 7.3% of proceeds in repeat public offerings and 16.9% in initial public offerings. Table 1 also provides data on floatation costs broken down according to the type of filing used to register the stock, and shows that typical costs are lowest for issuers using Form S-3 shelf offerings (5.0%) and highest (almost 20 - 30%) among the small-business filers that use Form ---------FOOTNOTES---------- -[1]- Inmoo Lee, Scott Lockhead, Jay Ritter and Quanshui Zhao, The Costs of Raising Capital, Journal of Financial Research, Vol. XIX, No. 1, pp. 59-74 (Spring 1996). ==========================================START OF PAGE 4====== SB-2.-[2]- ---------FOOTNOTES---------- -[2]- Form SB-2 is a short-form registration statement available to small businesses. One reason, seen in Table 1, that the offering costs for SB-2 filers is a higher proportion of proceeds is that the typical SB-2 offer yields just $6 million in proceeds, compared to $78 million for shelf offerings. ==========================================START OF PAGE 5====== Table 1 - see accompanying link Floatation costs are higher for small business issuers for reasons unrelated to regulation, but a differential regulatory ==========================================START OF PAGE 6====== burden is the best explanation for the lower floatation costs experienced by S-3 issuers as compared to S-1 issuers. For repeat offerings of common stock by seasoned issuers, S-1 issuers incur costs totalling approximately 9.2% of proceeds, whereas S-3 (non-shelf) issuers incur costs totalling approximately 6.3% of proceeds, and S-3 (shelf) issuers incur costs totalling 5.0% of proceeds. These differences are only partly attributable to the larger offer size seen in offerings on Form S-3. Table 1b below reports typical offering costs for various sized offers, and a pattern of lower costs for offerings utilizing Form S-3 is found within each size-based subgroup. Table 1b - see accompanying link ==========================================START OF PAGE 7====== The single largest determinant of the lower costs seen in the S-3 shelf filings is the ability to distribute the securities at the current market price upon takedown, rather than at a discount to the market price as seen in offerings utilizing Form S-1 or Form S-3 non-shelf. These cost savings are indicative of the benefits of "just-in-time" financing techniques that would be available to company-registered issuers. It is the Committee's hope and expectation that an increase in an issuer's flexibility to go to market in a more streamlined manner could result in further reductions in the direct costs of public offerings. Lower direct costs could translate into lower costs of capital in numerous ways. Allowing for the adoption of just-in-time capital techniques, whereby companies can access the market exactly when they want and for the exact amount they want, will help eliminate the discount from the market price currently experienced in non- shelf public offerings of common stock. In addition, by extending the benefits of the streamlined offering process and creating greater flexibility regarding the delivery of disclosure documents to investors, underwriting, legal and printing costs should be reduced further. ==========================================START OF PAGE 8====== 2. Delay and Uncertainty Caused by Commission Staff Review The time consumed by the registration process represents an indirect cost for issuers. Under the current system, no sales of securities are allowed until the Commission has declared a registration statement to be effective. During this waiting period, the length of which may be affected by whether the Commission staff reviews the document, issuers may miss a desired market window. Under the current Commission staff's selective review criteria, all registration statements for initial public offerings (IPOs) are reviewed by the staff. In addition, pursuant to internal selective review criteria, the staff may choose to review any other registration statement filed with the Commission, including shelf registration statements when initially filed to register securities for the shelf. Prior to filing a registration statement, even the most seasoned issuer will not know whether its registration statement will be reviewed, or the length of the time delay resulting from the review process if there is a staff review. Issuers trying to sell securities, other than off a shelf registration statement previously declared effective, consequently cannot predict in advance exactly when they will be able to go to market.-[3]- ---------FOOTNOTES---------- -[3]- For shelf offerings, the shelf registration statement may not be used until declared effective by the staff. And, as a practical matter, most initial takedowns off a shelf occur shortly after (continued...) ==========================================START OF PAGE 9====== Often, they will prepare two different time schedules when planning a public offering -- one assuming Commission review, and the other assuming no review -- and the difference between these two timetables can be substantial.-[4]- If a registration statement is reviewed, the staff does not comment on the merits of an offering. Rather, the staff evaluates the adequacy of the issuer's disclosures. Staff review encompasses the disclosure in the registration statement as well as in the company's Exchange Act reports and any other documents on file with the Commission. Under shelf registration, however, the staff does not review prior to its use the prospectus supplement containing transactional information that is used in taking down securities off the shelf for public sale. After receiving staff comments, issuers may respond to the issues raised in the comment letter by revising disclosures in the registration statement and other corporate disclosures (including possibly Exchange Act reports) to address the staff's concerns, by explaining in a supplemental letter to the staff why ---------FOOTNOTES---------- -[3]-(...continued) the registration statement becomes effective. Thus, the staff review process may still pose a real impediment to shelf takedowns. However, because the issuer may register up to the amount of securities that it expects to issue in the next two years, and there generally is no post- effective staff review of takedown prospectuses, theoretically this delay does not have to occur frequently. -[4]- Transcript of May 8, 1995 Advisory Committee Meeting at 227 (statement of Gerald Backman). ==========================================START OF PAGE 10====== revisions are not necessary, or both. After the issuer resolves the concerns raised by the staff, the registration statement is declared effective. In the extreme, where an issuer misses a market opportunity while responding to the staff's inquiries, the company will have expended significant funds preparing for an unsuccessful offering (although, for a shelf issuer where registration statement has been declared effective, the issuer can use the effective shelf at a subsequent time). The mere prospect of such uncertainty and delay may cause an issuer to forego a registered offering. Table 2 below provides a Committee staff analysis of recent issuer experience with staff review, covering the frequency of review and the average length of waiting periods. These results are given for registration statements of underwritten offerings of common stock that were declared effective during 1994 and 1995. During that period, all initial public offerings received a full review. In addition, pursuant to selective review, less than one in six Form S-3 shelf and non-shelf registration statements were reviewed, and approximately one-third of all other registration statements for repeat offerings were reviewed. ==========================================START OF PAGE 11====== Table 2 - see accompanying link The typical time period between the filing and the effectiveness of the registration statement was less than three months for an initial public offering and less than two months for repeat offerings. Waiting periods may be longer when the staff's review and comments are extensive and require substantial ==========================================START OF PAGE 12====== revisions to the registration statement before being declared effective, thereby introducing uncertainty into the capital formation process. Staff review also reduces the predictability of waiting periods, i.e., the length of the waiting period will vary more where the document is reviewed than when not reviewed. The degree to which waiting periods vary in length is illustrated in Figure 5 in the Addendum to this Appendix A, which is a histogram showing the relative frequency with which waiting periods of various lengths were observed among underwritten offers of additional common stock during 1993 and 1994. As shown in Figure 5, the distribution of the length of waiting periods is more tightly clustered around the average waiting period in the absence of a staff review. The length of the waiting period also is influenced significantly, however, by factors separate from the Commission review procedure, such as whether the disclosure in the registration statement when initially filed was significantly deficient, whether the issuer delayed or significantly altered the structure of the financing after the registration statement was filed, and whether the issuer's Exchange Act reports had been recently reviewed by the staff.-[5]- ---------FOOTNOTES---------- -[5]- Even if a document is not reviewed by the Commission staff, issuers can and do amend registration statements prior to effectiveness. On average, non-shelf registration statements that are not reviewed are amended at least once prior to effectiveness (compared to approximately three amendments if reviewed). Although shelf registration statements are amended less often (continued...) ==========================================START OF PAGE 13====== The risk that disclosed information is erroneous, incomplete or fraudulent is itself a significant uncertainty that can impose costs on the capital formation process. Thus, a potential benefit of the retention of Commission review of transactional disclosure documents arises from efforts by the Commission staff to compel issuers to disclose more fully information that would impact market perceptions of the value of the securities to be issued. The Committee strongly believes that staff review is important where the transaction involves IPOs or major restructurings. In these cases, the issuer in essence is beginning the disclosure process anew because the bulk of the information already available to the public, if any, is not as useful as in the case of a seasoned company doing a routine financing. In addition, the coverage by analysts and the efficiency of the markets in reviewing and absorbing the information and in pricing securities is less effective in these transactions than with routine repeat offerings by seasoned companies. By retaining staff review in these instances, corrective revisions of preliminary prospectuses prior to closing can enhance the quality of the disclosure provided to investors, ---------FOOTNOTES---------- -[5]-(...continued) than non-shelf registration statements after filing with the Commission, non-reviewed shelf registration statements are amended prior to effectiveness .5 times versus 2.4 times for reviewed shelf registration statements (although presumably some of these amendments in the latter category are voluntary). ==========================================START OF PAGE 14====== prevent later and more disruptive corrective disclosure, and reduce an issuer's exposure to litigation. In the case of Form S-3 eligible issuers doing routine offerings, however, where the market following these issuers is better informed and efficient, the benefits of any review process obviously are less certain.-[6]- Simply put, the efficacy of the continuous disclosure reporting scheme under the Exchange Act, including the review by the staff of operating and financial information filed on Form 10-K and other reports, may render unnecessary the separate pre-review by the staff of registration statements and other transactional filings by reporting companies. Some argue that the possibility of Commission review of seasoned issuer transactional filings provides significant deterrent value that serves to increase the quality of public disclosures. They argue these issuers voluntarily provide negative material disclosure without the benefit of an actual review, at least partially due to the possibility that they might be reviewed. Others argue that the primary motivator in ensuring proper disclosure is the fact that the issuer is subject to liability for market fraud and other civil liability and government enforcement actions for improper disclosures. In this respect, strict liability under Section 11 for material ---------FOOTNOTES---------- -[6]- In fact, the Division of Corporation Finance appears to acknowledge this in that it does not review takedown prospectuses in the context of shelf registrations and reviews only approximately 14 to 16 percent of Form S-3 (shelf and non-shelf) registration statements. ==========================================START OF PAGE 15====== misstatements undoubtedly serves to ensure appropriate compliance with the dictate of full and fair disclosure. In the Committee's view, it is inherently difficult to measure or quantify the incidence of or avoided costs related to false or misleading statements that are never made, either because of the possibility of staff review or the threat of liability. The staff of the Committee analyzed stock-price evidence in an effort to quantify the benefit to investors provided by the review process with respect to transactional filings by reporting companies. If the information generated by the staff review is predominantly negative, and if stock prices generally reflect publicly available information, then one could expect Commission reviews, at least in certain instances, to be associated with declines in stock prices relative to the market, on average, over the course of the review. Table 3 below provides evidence regarding the impact of Commission reviews on filings for underwritten public offerings of additional common stock by Nasdaq, NYSE and Amex-listed issuers during 1993 and 1994. The evidence in Table 3 shows no statistically significant difference in the average change in stock prices relative to the market according to whether or not filings are reviewed. Even if this data is construed as demonstrating that no new material information is generated by staff review of these transactional filings, that result should not be surprising. If the continuous disclosure requirements (including the threat of liability) and staff review of periodic reports are working as ==========================================START OF PAGE 16====== intended, then no material company-related information should be disclosed during the pre-effective review process. Moreover, the statistical test was only available for repeat offers by more seasoned issuers, and was only conducted for exchange-listed and Nasdaq issuers. Therefore, no evidence was considered on the value added by staff review in initial public offerings or in the case of the smallest companies, where the value added by staff review would be expected to be greater. Table 3 - see accompanying link ==========================================START OF PAGE 17====== On balance, and consistent with the thrust of the Commission's initiatives, the Committee believes that the cost and uncertainties created by the current Commission staff review process of transactional filings might be eliminated for most issuances by large seasoned companies without any adverse loss of deterrent effect, as long as those transactional disclosures, as well as the company's periodic and other filed reports, remain subject to staff review on a routine basis after the transaction, as well as remaining subject to Securities Act liability. The possibility that a company's periodic and other filed reports as well as transactional disclosure could be reviewed after the completion of the offering should be as effective as the deterrence currently provided by the possibility of review prior to going to market. 3. Residual Costs Associated With Registering Equity Securities On Shelf Registration Statements -- Pre-offering Filing Fees, Short-Selling and Market Overhang Recognizing the costs associated with the traditional registration process and staff review, the Commission over the last fifteen years has acted to alleviate delays in going to market by adopting the shelf registration process. This process allows seasoned companies to register securities in advance for sale at a later date. Shelf registration gives a company the flexibility to enter the market quickly by offering the previously registered securities "off the shelf," either in one offering or in several tranches. When the company decides to do such a "takedown," it files with the Commission, and delivers to ==========================================START OF PAGE 18====== investors, a prospectus supplement describing the terms of the securities and the specific offering. Issuers are permitted to use the prospectus supplement to market the securities prior to their sale. Although it may be reviewed subsequent to the offering, the prospectus supplement is not subject to Commission staff review prior to its use. Shelf registration also can be used for secondary distributions by selling shareholders who wish to time their sales to coincide with favorable market price movements. As originally adopted, shelf registration required the delineation of the specific amount of each class of security to be registered. In 1992, the Commission amended the rule governing the shelf procedure to allow "unallocated" or "universal" shelf registration where companies may register an aggregate dollar amount of one or more classes of securities without having to specify the amount of each class of security that is registered.-[7]- Table 4 below reports on recent usage of shelf registration by corporate issuers of additional securities (i.e., repeat offerings). During the period from January 1992 through December 1995, on a value-weighted basis, shelf registration was used for approximately one-half of all underwritten offers of preferred stock and approximately 40 percent of all underwritten offers of ---------FOOTNOTES---------- -[7]- Simplification of Registration Procedures for Primary Offerings, Securities Act Rel. 6943 (July 16, 1992) [57 FR 32461 (July 22, 1992)] (the "Primary Offerings Procedures Release"). ==========================================START OF PAGE 19====== corporate debt, but only approximately ten percent of all underwritten offers of common stock. While sellers of additional common stock are still less likely to use a shelf registration than are sellers of preferred stock and debt, the year-by-year changes reported in Table 4 show that sellers are increasingly using the shelf registration process to sell common stock. In 1992, takedowns from shelf registrations amounted to three percent of all underwritten offers of additional common stock. In 1994 and 1995, fifteen percent of the total value of additional underwritten common stock issues came from shelf registrations.-[8]- Indeed, a recent Wall Street Journal article pointed out not only the increase in recent years in the number of shelf registration statements that include equity, but also the recent use of shelf takedowns to sell large amounts of equity in what are essentially "big block trades." -[9]- Table 4 - see accompanying link ---------FOOTNOTES---------- -[8]- Of the $9.4 billion in common stock sold using shelf registration from January 1992 through December 1994, the Committee staff estimates that at least $7.6 billion was sold using the unallocated shelf process. -[9]- Michael Santoli, Block Trades Test Traditions On Wall Street, Wall St. J., February 9, 1996, at B12B, col. 3 ("Santoli") ("Shelf filings that cover equity have steadily become more common, rising 18% to 110 in 1995 after climbing 26% in 1994"). ==========================================START OF PAGE 20====== One significant deterrent to the use of the shelf registration process has been issuers' fear of a dilutive "market overhang." Overhang often depresses the trading price of a company's stock once a registration statement is filed disclosing the issuer's plans to issue additional common stock. Generally, this market overhang effect seems more pronounced for smaller issuers. Committee member Dr. George Hatsopoulos submitted a compilation of repeat (mostly non-shelf) offerings of common stock under $50 million completed in the five-year period ending August 9, 1994 (1401 transactions) that showed an average decline of the issuer's stock price by six percent from the time of filing to the time of the public offering.-[10]- A ---------FOOTNOTES---------- -[10]- Documents for Advisory Committee Meeting, May 8, 1995, Tab C (Letter dated May 4, 1995 from George N. Hatsopoulos to Commissioner Steven M.H. (continued...) ==========================================START OF PAGE 21====== comparable analysis is reported in Table 3 above for repeat offerings of common stock by companies with pre-offer market capitalization (rather than offer size) of more or less than $100 million. Among smaller issuers, net-of-market stock price declines averaged approximately seven percent. Among larger issuers, there was no significant decline in stock prices on average, indicating that the market overhang effect appears less pronounced among the class of issuers that initially would be eligible for the company registration pilot. Some or all of the decline in the market price of smaller issuers could be due to anticipation of the dilutive effect of the new offering. The higher average floatation costs reported for smaller issuers in Table 1 above are consistent with this possibility. The market also may view a registration statement for possible future sales of common stock as a signal that, in management's view, the price of the stock has peaked. The evidence in Table 3 above, that price declines are concentrated among the smaller issuers, is consistent with this view, since smaller companies generally are less closely followed by analysts, and the investment community is generally less well informed about managements opinions. For these reasons, disclosure of an issuer's intent to issue a significant amount of equity can be material to investors particularly with respect to smaller companies. Dr. Hatsopoulos, ---------FOOTNOTES---------- -[10]-(...continued) Wallman) ("Hatsopoulos Letter"). ==========================================START OF PAGE 22====== however, raised concerns that prior public notice of an issuer's impending sale of additional common stock provides market arbitragers with an opportunity to sell the stock short, possibly exacerbating the anticipated price decline.-[11]- As stated by Dr. Hatsopoulos, [o]nce an offering is announced, [the arbitragers] sell the company's stock short with the intent to cover their short at the offering. Because of fear for such an activity, we decided many times in the past to do offerings offshore and register the shares after completion.-[12]- It has been reported elsewhere that short sellers tend to be active in the shares of companies once the company files a registration statement for a public offering of common stock, presumably because the pendency of an added supply of common stock reduces the likelihood that the short seller will be caught in a squeeze.-[13]- Ultimately, both the company and the ---------FOOTNOTES---------- -[11]- A market participant has described the phenomenon as a foolproof way to make money. The market has created a self-fulfilling prophesy about what will happen when you file: the price goes down, the short interest goes up, buyers go to the sidelines, and the deal comes at a much, much lower price. Bernstein, Some New Buyers Emerge From Gloom, BioCentury, The Bernstein Report on BIOBusiness, May 6, 1995, at A3. -[12]- Hatsopoulos Letter, supra n.10, at 4. -[13]- It is estimated that short interest during the period between filing date and offer date is approximately three times greater than it is in the three months before the filing date, based on a sample of 474 offerings of additional common stock by exchange-listed issuers. See Assem Safieddine and William J. Wilhelm, Jr., "An Empirical Investigation of Short-Selling Activity Prior to Seasoned Equity Offerings," December (continued...) ==========================================START OF PAGE 23====== existing shareholders suffer as a result of adverse effects on the market price of the company's stock, which could significantly raise the cost of equity capital for issuers. It was particularly because of these issuer concerns with potential market overhang that the Commission adopted the unallocated shelf procedure to facilitate the use of shelf registration for delayed offerings of common stock and convertible securities.-[14]- The recent upward trend in the percentage of all underwritten offerings of common stock that are made using the shelf registration process suggests that the 1992 introduction of the unallocated shelf procedure has met with some success. However, the continuing need to specify an aggregate dollar amount of securities to be offered apparently has perpetuated market overhang concerns. Industry participants advised the Committee staff that they still recommend against use of even the unallocated shelf for common stock offerings, except where the issuer is large enough to be less susceptible to market ---------FOOTNOTES---------- -[13]-(...continued) 1995, Unpublished Paper, Boston College. SEC rules prohibit short sales of equity securities in advance of public offerings, but only when the short sales are covered with securities sold in the offering. See Exchange Act Rule 10b-21 [17 CFR 240.10b-21]. -[14]- See Primary Offerings Procedures Release, supra n.7. ==========================================START OF PAGE 24====== overhang or where the issuer already has disclosed their intention to raise significant equity capital.-[15]- Although some market participants indicated potential interest in advance notice to the market of significant equity offerings, the Committee concluded that simultaneous notice to the market through the filing of a Form 8-K, as well as disclosure of the issuer's financing activities in other reports, should adequately serve to protect the interest of investors without requiring issuers -- at least seasoned issuers -- to signal their intentions months in advance. Indeed, in many instances under the company registration system, public notice of a specific offering would occur earlier than required today under shelf offerings, where transactions are disclosed in prospectus supplements first filed with the Commission up to two business days after their use. In the Committee's view, the long-term market overhang effect could be reduced, or even eliminated, under a company registration system that does not mandate the advance filing of a registration statement covering a specified dollar amount of securities, while appropriate notice to the market of an offering can be expedited through the company registration Form 8-K filing requirement. ---------FOOTNOTES---------- -[15]- Transcript of May 8, 1995 Advisory Committee Meeting at 146 (describing staff discussions with representatives of financial executives and underwriters); Documents for Advisory Committee Meeting, July 26, 1995, Tab E (Letter dated July 21, 1995 from Michael Holladay, General Attorney of AT&T, to the Committee). ==========================================START OF PAGE 25====== There are other limitations to the current unallocated shelf process that would be eliminated as a result of the implementation of a company registration system. First, a shelf may not be used until the shelf registration statement is declared effective by the staff, perpetuating much of the uncertainty and delay that the shelf system was adopted to address. Based upon information available to the staff, as of December 31, 1994, approximately 58% of the initial takedowns of securities off an unallocated shelf that included common stock occurred within 60 days of the initial filing of the Form S-3 registration statement. Approximately 39% occurred within 40 days of the filing. In roughly 50% of the offerings, half the time between the filing of the registration statement and the initial takedown occurred prior to the effective date. Second, the filing fee for shelf registration is non- refundable and payable at the time of registration rather than upon the actual takedown of securities (unlike the "pay-as-you- go" structure of company registration). Third, in most cases, the issuer only may register on the shelf an aggregate dollar amount of securities that it reasonably expects to be offered and sold within the next twenty-four months. Moreover, in the case of at-the-market offerings of equity securities,-[16]- the ---------FOOTNOTES---------- -[16]- An "at-the-market" offering is an offering of securities into an existing trading market for outstanding shares of the same class at other than a fixed price on or through the facilities of a national securities exchange or to or through a market maker otherwise than on an exchange. (continued...) ==========================================START OF PAGE 26====== offering must be conducted by an underwriter and the amount of any voting stock that is registered for this purpose may not exceed ten percent of the aggregate market value of the registrant's outstanding voting stock held by non-affiliates. Company registration also would create more flexibility regarding prospectus delivery than the current shelf system. Shelf issuers are required to deliver a final prospectus no later than delivery of the confirmation, and are restricted in the use of selling materials or term sheets absent prior or simultaneous delivery of the prospectus. Finally, company registration would make the streamlined offering process available in connection with material acquisitions, whereas the current shelf registration system generally does not. ---------FOOTNOTES---------- -[16]-(...continued) Securities Act Rule 415(a)(4)(i) [17 C.F.R. 230.415(a)(4)(i)]. ==========================================START OF PAGE 27====== B. Indirect Costs Associated with the Current Regulatory Scheme 1. Securities Act Concepts Designed to Ensure the Registration of Public Offers and Sales Can Produce Unnecessary Costs and Uncertainties and Reduce Flexibility in Structuring Financing Transactions Gun-jumping. Any improper soliciting activities prior to, or during, the registration process (generally referred to as "gun-jumping" or "beating the gun")-[17]- violate the registration requirements of the Securities Act. These restrictions apply to both large, seasoned public companies that have been publicly reporting for years, as well as small, non- public companies contemplating an initial public offering. If the Commission staff determines that gun-jumping has occurred, the effective date of the registration statement may be delayed in an effort to mitigate the effects of the improper publicity on the market.-[18]- Although the Commission's policies in this area are not intended to restrict the ordinary flow of information to investors and analysts, the difficulties of drawing clear distinctions between permitted and prohibited market communications have led some reporting companies to limit their ordinary course disclosures to the marketplace while ---------FOOTNOTES---------- -[17]- See generally Stanley Keller, Basic Securities Act Concepts Revisited, INSIGHTS, May 1995, at 5 (the "Keller Article"). -[18]- Gun-jumping also can afford purchasers a right of rescission under Section 12(a)(1) of the Securities Act. ==========================================START OF PAGE 28====== contemplating or conducting a public offering.-[19]- Thus, although the gun-jumping doctrine may serve to protect purchasers in the offering by hindering circumvention of the registration requirements, it also may chill or delay the disclosure of some company-related information that is beneficial to the marketplace. The Committee questioned whether the chilling effect of the gun-jumping doctrine serves investor protection when the issuer is required to supply the markets with extensive public disclosures on an ongoing basis through its Exchange Act filings. Integration and General Solicitation Doctrines. In addition to the statutory "gun-jumping" restrictions, certain technical distinctions and concepts have evolved to prevent issuers from evading the protections of Securities Act registration by publicly distributing unregistered securities through private placements, or through affiliates acting as conduits to the public. Such distinctions and concepts have injected a significant degree of legal uncertainty into the capital ---------FOOTNOTES---------- -[19]- Although not necessarily representing the current views of the Commission or the Commission staff, this cautious approach is based upon longstanding Commission pronouncements in this area. See Guidelines for the Release of Information by Issuers Whose Securities Are in Registration, Securities Act Rel. 5180 (August 6, 1971) [36 FR 16506 (August 21, 1971)] (although companies are free to publish factual information while in registration, they must refrain from making "predictions, projections, forecasts, or opinions with respect to value"). See also Securities Rel. 5009 (Oct. 7, 1969) [34 FR 16870] and 4697 (May 28, 1964) [29 FR 7317]. ==========================================START OF PAGE 29====== formation process, thereby generating additional costs. The Committee also questioned whether such distinctions are necessary in the case of a seasoned issuer for which the same level of information is continuously provided to the markets as would be provided through the registration process. Under the federal securities laws, in certain circumstances, separate offerings that could each independently meet the conditions for an exemption from registration may be deemed to be "integrated" into a single offering for which no exemption is available. The integration test applied by the Commission-[20]- is intended to prevent issuers from circumventing the registration requirements by dividing a single plan of financing into separate offerings in order to obtain an exemption that would not be available for the entire transaction. There are a few safe harbors that offer some level of comfort by assuring non-integration of certain exempt offerings separated by at least six months from another offering.-[21]- If an ---------FOOTNOTES---------- -[20]- The SEC applies a five-factor test to determine whether separate offerings are to be integrated, or combined into a single offering. Integration may be required when: (1) the offerings are part of the same financing plan; (2) the offerings are made for the same general purpose; (3) the same class of security is issued in each of the offerings; (4) the offerings are made at or about the same time; and (5) the same kind of consideration is to be received in each of the offerings. See Non-Public Offering Exemption, Securities Act Rel. 4552 (November 6, 1962) [27 FR 11316 (November 16, 1962)]. -[21]- See Securities Act Regulation D [17 C.F.R. 230.502]; Securities Act Rule 147 [17 C.F.R. (continued...) ==========================================START OF PAGE 30====== issuer is unable to comply with a safe harbor, depending on the facts, its otherwise exempt offerings may be integrated, resulting in a Section 5 violation. A private offering also may lose its exempt status if, under the integration test, it is integrated with a registered offering and considered a single public offering.-[22]- A private placement of the same security that is the subject of a registration statement might avoid integration, however, if the same transaction were structured differently, e.g., if the registered security was sold off a shelf registration statement.-[23]- Needless to say, some of these distinctions have been condemned as "form over substance" and as "metaphysics."-[24]- ---------FOOTNOTES---------- -[21]-(...continued) 230.147]. -[22]- A completed non-public offering under 4(2) will not lose its exempt status as a result of a subsequent registered offering of the same class of securities. See Securities Act Rule 152 [17 C.F.R. 230.152]. A 4(2) offering will be deemed completed when the purchasers' investment decision is finalized, meaning consummation of the transaction is no longer subject to any conditions within the purchaser's control. See Black Box, Inc., SEC No-Action Letter [1990 Transfer Binder] Fed. Sec. L. Rep. (CCH) 77,256 (June 26, 1990). -[23]- See Documents for Advisory Committee Meeting, May 8, 1995, Tab H (Memorandum dated April 26, 1995 from William J. Williams, Jr. to the Advisory Committee). -[24]- See, e.g., Gerald S. Backman and Stephen E. Kim, A Cure for Securities Act Metaphysics: Integrated Registration, INSIGHTS, May 1995, at 18. ==========================================START OF PAGE 31====== Companies that tend to raise capital more frequently can be unduly burdened by the integration concept. Companies that want to conduct multiple exempt offerings within a compressed time frame often are unable to wait the necessary six months to rely on a safe harbor from integration. Also, issuers that use securities as consideration for multiple small acquisitions run the risk of having those offerings integrated -- even in situations where the acquisitions have been negotiated on a face- to-face basis between sophisticated parties. A separate concern arises from the prohibition on general solicitations in private offerings. The general solicitation doctrine is intended to prevent a broad-based offer of securities without the mandated protections of the Securities Act registration process. Therefore, public dissemination of information regarding an anticipated or pending private offering may be deemed to be a general solicitation, which would adversely impact an issuer's ability to rely on a valid exemption from registration under the Securities Act. However, since an unregistered distribution or placement of a large amount of a public company's securities, particularly common stock, can have a material effect on the issuer, and can result in significant dilution of existing shareholders, information about financing activities can be important to the market and the company's existing shareholders. The Commission has attempted to provide some guidance to help issuers distinguish between acceptable market disclosure and prohibited ==========================================START OF PAGE 32====== general solicitations.-[25]- Nevertheless, news about private placements is widely disseminated. In fact, third parties routinely publicize information about pending private placements, including information that would be outside the permitted scope of the safe harbor if attributed to the issuer.-[26]- Ratings are now routinely published concerning planned private offerings.-[27]- Thus, the ---------FOOTNOTES---------- -[25]- In 1994, the Commission enacted a safe harbor permitting reporting issuers to disclose publicly certain limited information regarding proposed unregistered offerings. Information that is more pertinent to the offering process, such as the underwriter's name, may not be disclosed. See Securities Act Rule 135c [17 C.F.R. 230.135c], as adopted in Simplification of Registration and Reporting Requirements for Foreign Companies; Safe Harbors for Public Announcements of Unregistered Offerings and Broker-Dealer Research Reports, Securities Act Rel. 7053 (April 19, 1994) [59 FR 21644 (April 26, 1994)]. In addition, the Commission has proposed to amend its annual and quarterly report forms to mandate disclosure of unregistered placements of common equity (and common equity equivalents) in an issuer's periodic reports. See Streamlining Disclosure Requirements Relating to Significant Business Acquisitions and Requiring Quarterly Reporting of Unregistered Equity Sales, Securities Act Rel. 7189 (June 27, 1995) [60 FR 35656 (July 10, 1995)]. -[26]- For instance, publications such as the Private Placement Letter provide detailed information on a weekly basis regarding rumored and completed private placements, often naming the investment banking firm(s) acting as placement agent or underwriter and discussing ranges of pricing information. -[27]- See Anne Schwimmer, S&P to Rate 144A Bond Deals Just Like Public Offerings; But Tricky Questions Still Remain For the Public/Private Hybrid, Investment Dealers' Digest, March 4, 1996, at 12, stating that "Standard & Poor's has begun to (continued...) ==========================================START OF PAGE 33====== boundaries of the general solicitation doctrine are breaking down since the very information prohibited under the doctrine is routinely being released to both the market and potential offerees prior to completion of the private placement. Indeed, the Commission recently solicited comments on the continued viability of the prohibition against general solicitation in private offerings.-[28]- The general solicitation concept has other consequences that burden an issuer's flexibility in structuring transactions without furnishing any counterbalancing investor protections. For instance, the Commission staff takes the position that the filing of a registration statement covering a specific securities offering (as contrasted with a shelf registration), even without offering activity, may constitute a general solicitation for that securities offering.-[29]- Consequently, with limited ---------FOOTNOTES---------- -[27]-(...continued) publicly release ratings on many Rule 144A private placements -- hammering home the market's view that most of these private placements are de facto public bonds behind the private veneer." Moody's Investors Service already rates 144A deals. -[28]- Exemption for Certain California Limited Issues, Securities Act Rel. 7185 (June 27, 1995)[60 FR 35638 (July 10, 1995)]. -[29]- See Circle Creek AquaCulture V, L.P., SEC No- Action Letter (March 26, 1993)("The staff also is unable to concur in your view that the prior registered offering would not constitute a "general solicitation" for purposes of rule 502(c) of Regulation D"); Letter from John J. Huber, Former Director of the Division of Corporation Finance, to Michael Bradfield, Former General Counsel of the Board of Governors of the Federal (continued...) ==========================================START OF PAGE 34====== exceptions, a private offering of the same or similar security undertaken while a non-shelf registration statement is pending or immediately following the registered offering could be tainted by the earlier general solicitation resulting in a Section 5 violation. This result may occur even if the issuer decides to abandon the public offering and withdraw the registration statement. The Commission staff also has viewed the solicitation of offerees based on the private offering exemption to be inconsistent with a subsequent filing to register the sale of the privately offered securities to the same investors.-[30]- Viewed as a single transaction, the offer was made before the filing of the registration statement and therefore constitutes gun-jumping. Such a scenario may arise where the issuer seeks to "test the waters" by soliciting indications of interest in a contemplated offering or the issuer files the registration statement after the purchasers are committed to purchase to avoid giving them restricted securities (rather than registering the resale of the securities acquired by the purchasers, as in so- ---------FOOTNOTES---------- -[29]-(...continued) Reserve System (March 23, 1984) ("The filing of a registration statement constitutes an offer to the public and thus a general solicitation of investors which precludes reliance on the exemption provided by Section 4(2)"). -[30]- See Summary of Capital Raising, Acquisition and Other Activity Involving the Division of Corporation Finance, THE SEC SPEAKS IN 1996, Vol. 1, at 146 (the "Current Issues Outline"); Keller Article, supra n.17, at 9. ==========================================START OF PAGE 35====== called "PIPES" transactions).-[31]- Section 5, in the view of the staff, requires that the offer and the sale both be either private or public.-[32]- Otherwise, the registration of the sale to investors solicited privately "would deprive public purchasers from those investors of the protection of registration."-[33]- It is questionable whether the validity of exemptions from registration should depend on slight gradations in the structure of transactions, especially where the transactions do not differ in their economic substance. Because in some instances there are no bright-line tests for determining when separate offerings will be integrated, some argue that issuers often incur considerable expense and delay in procuring legal opinions on this point and in structuring transactions to satisfy formulaic and formalistic interpretations. Consequently, the Committee concluded that the integration and general solicitation concepts often needlessly complicate a company's capital-raising activities. Since in the case of seasoned issuers, the registration process often does not provide any additional disclosure concerning the issuer to the markets, preservation of these concepts can only be justified by the need to ensure the sanctity of the transactional registration ---------FOOTNOTES---------- -[31]- "PIPES" refers to "private investment, public equity." Keller Article, supra n.17, at 7. -[32]- See Current Issues Outline, supra n.30. -[33]- Keller Article, supra n.17, at 6. ==========================================START OF PAGE 36====== requirements. The recommended pilot would address these issues - - at least for those issuers initially eligible for the pilot -- by treating all offers and sales by a registered company as registered for disclosure and liability purposes, regardless of whether made on a public or private basis. Once company registration is extended to all issuers (with whatever additional protections, if any, are needed for investors), these concerns could be addressed directly for smaller issuers as well.-[34]- Constraints on Resales - Statutory Underwriters and Affiliates. Although Section 4(1) of the Securities Act provides an exemption from registration for sales of securities by persons other than an "issuer, underwriter or dealer," under the current system registration may be required when "restricted" securities (securities issued in a private placement) are resold by investors. Furthermore, the registration requirements place restrictions on the ability of a person who controls or is controlled by or under common control with the company, i.e., an "affiliate," to resell both restricted and unrestricted securities.-[35]- This restriction also extends to persons ---------FOOTNOTES---------- -[34]- Until such time as the company registration system completely replaces the current system, other initiatives may address certain of these issues. See, e.g., the proposal for "pink herring" registration of offers, as described in the Report of the Task Force on Disclosure Simplification to the Securities and Exchange Commission (March 5, 1996) ("Task Force Report"), at p.31. -[35]- To ensure that routine trading transactions between individual investors do not trigger the (continued...) ==========================================START OF PAGE 37====== or entities that are affiliates of a company that was acquired by the issuer in exchange for the issuer's securities.-[36]- Consequently, this restriction may hinder a public company in using its securities for business acquisitions. These constraints arise from the broad interpretation of the statutory ---------FOOTNOTES---------- -[35]-(...continued) disclosure obligations associated with registered public offerings, Section 4(1) of the Securities Act [15 U.S.C. 77d(1)] provides an exemption from registration for transactions by a "person other than an issuer, underwriter or dealer." Purchasers from the issuer who sell their securities nevertheless may be deemed to be "statutory underwriters," and hence unable to rely on Section 4(1), if they are found to have acted as links in a chain of transmission of securities from the issuer to the public. Section 2(11) [15 U.S.C. 77b(11)] provides that persons who control, or are controlled by, or under common control with the issuer shall be considered "the issuer" for the purposes of determining who is an underwriter. Thus, distributions of outstanding securities can trigger the application of the underwriter concept to require registration if the sale is by or on behalf of an affiliate of the issuer. The statutory provision applies even where the affiliate acquired the shares in the open market or in a registered offering by the issuer. -[36]- When an issuer offers securities in exchange for other securities in certain business combinations, or in certain asset acquisitions, the offer and subsequent exchange may be deemed an offer and sale for the purposes of the Securities Act. Securities Act Rule 145 [17 C.F.R. 230.145]. Any affiliate of the acquired company who receives securities of the acquiror company and subsequently resells those securities in public transactions without registration may be deemed an underwriter of such securities unless they are sold in compliance with the quantity limitations and other restrictions of Rule 144 (except the holding period requirement). Rule 145(d) [17 CFR 230.145(d)]. ==========================================START OF PAGE 38====== definition of "underwriter" set forth in Section 2(11) of the Securities Act and are intended to protect the integrity of the registration scheme against the risk of an issuer's indirect distribution of securities to the investing public through affiliates or private placement participants. If such a distribution is deemed to occur through the conduit of a statutory underwriter, and the issuer is relying on a private placement exemption, loss of the Section 4(1) exemption by a seller may cause the issuer to lose its exemption as well. Despite Commission efforts in adopting and refining Rules 144 and 144A to provide guidance in this area and to limit the restraints on resales to only those situations where necessary to provide investor protection,-[37]- significant burdens and uncertainties remain. The Committee examined whether restrictions on resales continue to make sense in today's markets, particularly where the issuer files periodic reports under the Exchange Act. For these issuers, requiring separate registration of the resales generally does not provide any information that has not already been assimilated by the market ---------FOOTNOTES---------- -[37]- The Commission has provided detailed safe harbor protections under Rule 144 for resales of restricted securities and affiliate sales that are subject to various conditions, including holding periods, limitations on selling methods, and volume restrictions. Securities Act Rule 144 [17 CFR 230.144]. Similarly, under Rule 144A, the Commission has provided a safe harbor for resales of restricted securities to certain large sophisticated institutions, known as qualified institutional buyers, or "QIBs," subject to non- fungibility limitations and other requirements. Securities Act Rule 144A [17 CFR 230.144A]. ==========================================START OF PAGE 39====== from the company's Exchange Act reports. In such instances, the costs of monitoring compliance with Rule 144 by control persons and the diminished liquidity of shares held by any officer, director or substantial shareholder deemed an affiliate, do not appear to be justified. In addition, the Committee viewed the resale restrictions imposed on the affiliate of an acquired company who receives securities in an acquisition as reducing the incentives for the use of securities as consideration in acquisitions. As a consequence, both acquirors and acquirees could incur unnecessary costs, including potentially adverse tax consequences that may result if the parties resort to an acquisition for cash instead. The burdens created by these resale restrictions do not impact solely on the issuer and its affiliates. Institutional investors subject to regulatory capital requirements and liquidity standards, as well as other fiduciaries, must monitor and limit the amount of restricted securities in their portfolio. They also must monitor their resales to ensure compliance with Rule 144 and Rule 144A requirements. The institution's monitoring can become unduly complicated if it also holds registered securities of the same issuer, particularly where the securities are of the same class. It was hard for the Committee to justify segregation of the same securities based upon the method of issuance, especially since the subsequent purchaser of either the registered security or the non-registered security would rely on the same body of publicly available information to ==========================================START OF PAGE 40====== make its investment decision, regardless of which security was purchased. Company registration should eliminate the need for these restrictions on resales. The pilot, by eliminating most of the incentives for issuing restricted securities in exempt offerings and by narrowing the applicability of these resale restrictions to a much smaller group of those who are otherwise affiliates and underwriters, will significantly curtail the potentially unnecessary application of resale restrictions, including in the context of acquisitions. In this way, the pilot company registration system will provide a means for issuers to avoid the costs and risks associated with complying with these legal concepts adopted to police the transactional registration process. 2. Mandatory Prospectus Disclosure Requirements Do Not Meet Investor Needs in the Most Efficient Manner The requirement that a prospectus be delivered to investors in connection with an offering has traditionally been viewed as one of the most important protections of the Securities Act. In practice, however, many have begun to doubt the usefulness of delivery of a mandated disclosure document, particularly where full information concerning the issuer is readily available through the issuer's Exchange Act's filings. The delivery requirement does not appear to justify the costs in terms of the usefulness of the information provided. Instead of providing information of the kind and in the amount sought by investors, ==========================================START OF PAGE 41====== issuers often provide legalistic disclosure documents that are difficult to read, hard to understand, prepared with litigation in mind, and delivered after the investment decision is made.-[38]- Although there are no explicit Commission mandated disclosure requirements in Rule 144A placements other than from an antifraud perspective, investor demand has resulted in the use of 144A offering circulars oriented towards providing useful information to the prospective purchasers prior to their investment decision. This experience with Rule 144A demonstrates that meaningful disclosure will be provided even in the absence of an express delivery requirement, and in fact, may result in better and more meaningful disclosure delivered prior to, not after, the investment decision is made. -[39]- Under the current process, after the filing of the registration statement but before it is declared effective, the underwriter may use the waiting period to solicit indications of ---------FOOTNOTES---------- -[38]- Transcript of May 8, 1995 Advisory Committee Meeting at 156 (statement of Dr. Burton Malkiel). See also Documents for Advisory Committee Meeting, September 29, 1995, Tab E (Letter dated September 27, 1995 from The Association for Investment Management and Research to Commissioner Steven M.H. Wallman); Task Force Report, supra n.34, at 17. -[39]- Ironically, the current "all or none" requirements that impose disclosure and delivery obligations in registered offerings, but not in exempt offerings, has the effect of causing issuers to seek capital in the less regulated markets where investors have fewer legal remedies. Arie L. Melnik & Steven E. Plaut, Disclosure Costs, Regulation, and Expansion of the Private-Placement Market, 10 Journal of Accounting, Auditing, & Finance 23 (1995). ==========================================START OF PAGE 42====== interest or otherwise market the securities. Other than the preliminary prospectus, no written materials explaining the offering may be distributed to investors before the registration statement is declared effective. Following effectiveness of the registration statement, the final prospectus containing the information mandated by Section 10 of the Securities Act must be sent or given to investors before or at the time written selling materials are sent or given, as well as before or at the time the purchaser is sent or given the written confirmation of sale. Because these restrictions apply only to written statements, not oral selling efforts, the current system may actually encourage oral solicitations over written solicitations.-[40]- The prospectus delivery requirements thus make it difficult to deliver term sheets or computational material or otherwise provide useful information in writing to investors prior to the availability or finalization of all mandated information.-[41]- Moreover, in those instances where no preliminary prospectus or selling materials are distributed, the only prospectus that would ever be received by investors would be the final prospectus, which is not required to be delivered until the confirmation of sale. In fact, if the registered securities are listed on an exchange, the prospectus delivery requirement ---------FOOTNOTES---------- -[40]- Linda C. Quinn, Reforming the Securities Act of 1933-A Conceptual Framework, INSIGHTS, January 1996, at 25. -[41]- See Kidder Peabody Acceptance Corp. I, SEC No- action Letter (available May 17, 1994). ==========================================START OF PAGE 43====== may be satisfied merely by the issuer or underwriter delivering copies of the prospectus to the relevant exchange for the purpose of redelivery to members of the exchange upon their request.-[42]- Company registration will eliminate the often formalistic and unnecessary burden of physically delivering a formal prospectus and will provide issuers with the ability to decide what information to deliver to investors in connection with the marketing of a securities offering. This additional flexibility promises to provide investors with more relevant information in a more timely manner than if across-the-board prospectus delivery requirements continued to be imposed.-[43]- The proposed company registration system is crafted to achieve this goal by requiring information to be provided to the market earlier than under the current system, by permitting the provision of the ---------FOOTNOTES---------- -[42]- Securities Act Rule 153 [17 C.F.R. 230.153]. In addition, Securities Act Rule 174 [17 C.F.R. 230.174] exempts transactions in securities of a reporting company from the requirement under Section 4(3) of the Securities Act [15 U.S.C. 77d] that dealers deliver a prospectus to subsequent secondary market purchasers of the registered securities for a period of time after the registration statement has been declared effective. -[43]- In the words of one Advisory Committee member, "I am thoroughly convinced that a one-page prospectus would actually give investors more information and more protection and not less." Transcript of May 8, 1995 Advisory Committee Meeting at 157-158 (statement of Dr. Burton Malkiel). ==========================================START OF PAGE 44====== information to be more flexibly structured, and by requiring the information to be subject to statutory liabilities. ==========================================START OF PAGE 45====== III. Changes in the Markets and Offering Processes, and the Effect on Investor Protection The increasing blurring of the lines between public, private and offshore markets, the general shift of investment volume from the primary markets to the secondary trading markets, and the historical reform of the public offering process to facilitate capital formation have resulted in new offering and investment practices. These changes have raised concerns regarding the effectiveness of the regulatory process and traditional "gatekeeping" functions. Investor protection may be adversely impacted where the burdens of the registration process cause issuers to raise capital in the private and offshore markets absent the protections of registration. A. Attractiveness of Public, Private and Offshore Markets. Despite significant Commission efforts over the years to streamline the registration process, the domestic private placement market, as well as offshore markets, remain an important source of capital for U.S. companies. In the Committee's view, the ready availability of the private and offshore markets as alternatives to the registered public markets as sources of capital, as well as the interrelationship of these markets, must shape the regulatory policy for public offerings if the regulatory scheme is to meet its investor protection purposes. Although difficult to quantify because public disclosure of such information is limited, it is thought that legal and accounting fees are not likely to be as high in transactions effected in non-public and offshore markets as compared to non- ==========================================START OF PAGE 46====== shelf offerings made in the public market.-[44]- Non- registration, however, also may involve significant costs. Historically, securities have been offered in the private placement market at significant discounts to prevailing market prices, representing a significant cost of raising capital for issuers.-[45]- One reason for this discount is that investors in private placements (and certain other exempt offerings and offshore offerings) often must accept a "holding" period of illiquidity as "the price of the issuer's outflanking the Commission's registration procedures."-[46]- In return, investors demand and receive a discount from the prevailing price of the equivalent securities trading in the public markets. In fact, the Committee staff estimates that the typical discount from market value seen in private placements of common stock by NYSE, AMEX, and Nasdaq issuers is approximately 20 percent.-[47]- ---------FOOTNOTES---------- -[44]- Documents for Advisory Committee Meeting, May 8, 1995, Tab D (Memorandum for Members of the Advisory Committee on the Capital Formation and Regulatory Processes dated April 25, 1995 from Edward Greene and Larry Sonsini to Commissioner Steven M.H. Wallman). -[45]- See Documents for Advisory Committee Meeting, March 6, 1995, Tab F (Memorandum dated March 1, 1995 from Professor John Coffee to the Advisory Committee). -[46]- Id., at 2. -[47]- Based on the median discount observed in 67 private placements reported by Securities Data Corp. in the period January 1992 - December 1994, where a selling price was disclosed. In many (continued...) ==========================================START OF PAGE 47====== The offshore markets also are being accessed in lieu of the domestic public markets. In the 1980s, the increasing globalization of the world's securities markets, coupled with the growth and speed of the transactions in the Euromarkets, along with U.S. companies' increasing interest in diversifying their shareholder base and the ease of entry into foreign capital markets, led to a significant increase in offshore offerings of securities by U.S. issuers. In order to clarify the reach across national boundaries of the registration requirements of Section 5 for companies raising capital abroad, the Commission adopted Regulation S in 1990. In doing so, the Commission made clear that offers and sales of securities occurring outside the United States are not subject to the registration requirements of Section 5.-[48]- Industry participants have advised the Committee staff that U.S. companies resort to the offshore markets for a number of ---------FOOTNOTES---------- -[47]-(...continued) cases, however, a selling price was not disclosed. This discount is many times larger than corresponding discounts observed in public offerings and reported in Table 1 above, where the typical discount is 7.1% for IPOs and 1.2% for repeat offers. -[48]- Regulation S provides safe harbors for primary offerings and resale transactions abroad that comply with certain conditions, including prohibitions on resales back into the United States for certain periods of time. See Regulation S under the Securities Act [17 C.F.R.  230.901 to 230.904]. See also Problematic Practices Under Regulation S, Securities Act Rel. 7190 (June 27, 1995) [60 FR 35663 (July 10, 1995)] (the "Regulation S Release"). ==========================================START OF PAGE 48====== reasons, including the desire to avoid the Commission and state blue sky registration requirements, or even to minimize the potential risk of loss of exemptions available for private placements. Some companies also use offshore offerings in connection with acquisitions because of the costs and other burdens of complying with Commission and U.S. GAAP requirements governing presentation of the acquired company's reconciled pro forma financial statements.-[49]- B. Blurring of Distinctions Between Public, Private and Offshore Markets. The inability to partition markets based on their regulated or unregulated status suggests that application of regulatory protections should be focused on the issuer rather than any particular transaction. By eliminating distinctions based upon the circumstances under which a security was originally issued, and instead improving the disclosure publicly disseminated by the issuer on an ongoing basis, investors in all the markets for the issuer's securities would benefit. As stated by Stanley Keller at the May 8, 1995 Committee Meeting, for all practical and economic purposes, the public and private markets are merging.-[50]- Any distinctions ---------FOOTNOTES---------- -[49]- See Streamlining Disclosure Requirements Relating to Significant Business Acquisitions and Requiring Quarterly Reporting of Unregistered Equity Sales, Securities Act Rel. 7189 (June 27, 1995) [60 FR 35656 (July 10, 1995)]. -[50]- See Transcript of May 8, 1995 Advisory Committee Meeting at 208 (statement of Stanley Keller). ==========================================START OF PAGE 49====== between the two markets have become blurred. The traditional delineations between registered securities and restricted securities have become confused through the use of strategies to minimize the impact of the resale restrictions on privately placed securities. For instance, holders of securities subject to resale restrictions, including affiliates, holders of restricted securities issued in private placements, and offshore purchasers in Regulation S offerings, are resorting to various hedging techniques (including short sales and equity swaps) to avoid or reduce the economic impact of such restrictions.-[51]- In addition, under certain conditions, issuers may resort to the use of "A/B exchange offers" to give purchasers of non- registered securities the benefits of a freely tradeable security without having to delay the offering by undergoing the registration process at the original offering stage.-[52]- ---------FOOTNOTES---------- -[51]- See Managing the Managers, The Economist, February 10, 1996, at 19. -[52]- Under the current system, privately placed securities may be registered for resale if the issuer is willing to agree to pay that expense. Resale registration often occurs promptly after the closing of the private placement. In the resale registration statement, resellers must be named as selling shareholders. Therefore, they could be subjected to statutory underwriters' liability under circumstances where it may not be feasible or economical for them to make a reasonable investigation of the issuer's public disclosures. There also is a prospectus delivery obligation. Pursuant to a line of no-action letters, the so-called "A/B exchange offer" allows certain restricted securities to be converted into (continued...) ==========================================START OF PAGE 50====== In the case of issuers who are already reporting issuers prior to the issuance of the restricted securities, the structure of this process seems to be an unnecessary formalism devised to ensure technical compliance with the transactional mandates of the Securities Act.-[53]- Further, while difficult to defend on a legal or economic basis, the Commission's line-drawing prohibiting the use of the A/B exchange offer for common equity of domestic issuers, like the non-fungibility requirement of Rule 144A, appears necessary solely to prevent the wholesale undermining of the current registration scheme, not to protect purchasers of the securities in the trading markets. ---------FOOTNOTES---------- -[52]-(...continued) freely tradeable securities through the mechanism of a registered exchange offer of an identical security without all of the holders being classified as underwriters. See Exxon Capital Holding Corporation, SEC No-Action Letter (available May 13, 1988). See also Shearman & Sterling, SEC No-Action Letter (available July 2, 1993). The A/B exchange offer procedure is available only for nonconvertible debt securities, certain types of preferred stock, and initial public offerings or initial listings in the U.S. of common stock of foreign issuers. See Keller Article, supra n.17, at 6. This procedure is not available for common stock of domestic issuers, or of foreign issuers who already are reporting companies, nor is it applicable to market professionals who continue to be considered statutory underwriters. -[53]- At the May 8, 1995 Advisory Committee meeting, Mr. Keller described this process as really like taking a rubber stamp and just stamping on [the security] registered. Transcript of May 8, 1995 Advisory Committee Meeting at 208 (statement of Stanley Keller). ==========================================START OF PAGE 51====== Distribution practices and pricing also reflect a convergence in public and private markets. What used to be thought of as public offerings are being done privately under Rule 144A. Bearing close resemblance to public offerings, Rule 144A placements often are facilitated by investment banking firms and accompanied by detailed offering circulars making extensive disclosures regarding the offering as well as the company and its financial condition. In the traditional private placement arena, the movement is towards more standardized documentation, which minimizes the opportunities for investors to negotiate terms or to conduct individual due diligence.-[54]- Some investment banks even have combined or closely aligned different practice groups (both public and private) in order to compete for business in a competitive marketplace.-[55]- ---------FOOTNOTES---------- -[54]- See ACIC Designs Pamphlet to Make Private Market User Friendly, Corporate Financing Week, February 20, 1995, at 6. See also Private Placement Process Enhancements, American College of Investment Counsel, Transaction Process Enhancement Committee (January 1995). -[55]- See Kimberly Weisul, Integrating Private and Public Product at Merrill; 'The Lines Continuously Blur' Between Two Teams Sitting 30 Feet Apart on Merrill's Trading Floor, Investment Dealers' Digest, August 28, 1995, at 19. In addition, the same article states that Goldman, Sachs & Co. also is well-noted for the close collaboration between its private and public teams. See also Ronan Donohue, The Private Market's Creative Drive; The Private Placement Market Has Become So Creative That the Exotic is Commonplace, Investment Dealers' Digest, March 4, 1996, at 14 ("Donahue"), stating that "most investment banks have moved to house 144A activity under the capital markets umbrella with all the fervor of syndicate selling (continued...) ==========================================START OF PAGE 52====== Likewise, on the buy side, the line between debt issued under Rule 144A and the public bond market also has become thin.-[56]- Due to the active participation of mutual funds as both buyers and sellers of Rule 144A debt securities, liquidity is readily available, even without subsequent registration.-[57]- In fact, participants in the market have come to view the designation of a security as a "Rule 144A security" as more of a technicality rather than as a distinction of any economic consequence.-[58]- Further evidence of the blurring of the private and public markets is provided by recent news articles discussing the shrinking of the traditional pricing premium on debt offerings in both the traditional private placement market and the Rule 144A ---------FOOTNOTES---------- -[55]-(...continued) and screen-based trading. At Salomon, underwritten 144As are executed like public deals . . . . Merrill Lynch has practically amalgamated the two activities, as has Goldman Sachs." -[56]- See, Donahue, supra n. 55, at 24, stating that "further evidence emerged during the year that the fine line between the 144A and the public bond market is becoming almost gossamer." -[57]- Mutual Funds Are Key to 144A Bond Liquidity, Private Placement Letter, September 18, 1995, at 12. -[58]- As stated by a trader, "I bought a couple of 144As yesterday and, quite frankly, forgot they were 144As. . . . The forms came across my desk to remind me. . . . Other than to comply with technical restrictions, we don't even really think of 144A as a category." Id. ==========================================START OF PAGE 53====== market.-[59]- With regard to the private placement market, "ferocious competition has driven down both spreads for investors and fees for intermediaries."-[60]- Likewise, as the Rule 144A market for the securities of domestic issuers has grown, the market has become more efficient and liquid, thereby reducing the illiquidity premium. The liquidity provided by both registration rights and the A/B exchange offer technique also could be contributing to the narrowing of spreads in the Rule 144A market. However, the regulatory burdens for equity are still significant (with U.S. issuers of common equity generally not being able to avail themselves of the beneficial treatment under Rule 144A or A/B exchange offers), thereby still imposing significant costs on issuers. ---------FOOTNOTES---------- -[59]- See Anne Schwimmer, Should Retail Investors Buy Private Placements?; "After Three Years, You Can Sell It to Grandma," Investment Dealers' Digest, August 28, 1995, at 11. See also Anne Schwimmer, 144A Bond Market Surges with Volume and Liquidity; Reaches Critical Mass after Years of False Starts, Investment Dealers' Digest, August 21, 1995, at 12; Rosalyn Retkwa, Private Placements Push for Strategic Part in Corporate Finance Picture, Corporate Cashflow Magazine, December 1995, at 26. -[60]- Welcome to the Free-for-All; Private Placement Bankers Adjust to a Radically Changing Marketplace, Investment Dealers' Digest, August 28, 1995, at 14. See also Private Placements Becoming Cheap Alternative to Public Markets, Corporate Financing Week, April 17, 1995, in which market participants state that "[p]rivate placement yield spreads have tightened and fees have shrunk to the point where it is often cheaper for issuers with less than $100 million of debt to tap the private versus the public market." ==========================================START OF PAGE 54====== In addition, the increasing use of the offshore markets by U.S. issuers has raised regulatory concerns regarding the effectiveness of rules separating the offshore and domestic markets, particularly where the only trading market for the security is in the United States.-[61]- Due to the resale restrictions on Regulation S securities, upon issuance, they are not supposed to trade freely with any comparable securities in the United States. Consequently, the Regulation S securities, particularly equity, usually are priced at a discount to the U.S. market price. Non-U.S. investors may attempt to capture this spread, however, by creating short positions in the United States with the intent to cover the position with the lower priced ---------FOOTNOTES---------- -[61]- The legal risk of flowback of securities issued offshore into the domestic public markets increases substantially with equity offerings by U.S. issuers of listed securities, particularly where there is no market for the securities outside the United States. See Edward F. Greene and Jennifer M. Schneck, Recent Problems Arising Under Regulation S, INSIGHTS, August 1994, at 2 (the Greene/Schneck Article ). Any such flowback without a valid exemption would expose the issuer to Commission and private litigation based on the failure to register the securities. While it is possible to register for resale securities initially offered outside the United States through the use of a "flowback" registration statement, unless the entire offshore distribution is registered for flowback, there would be practical difficulties in determining which of the securities were registered under the Securities Act given the fungibility of securities in the secondary markets. See Ronald R. Adee, Flow-back Registration Statements, INSIGHTS, April 1988, at 10. ==========================================START OF PAGE 55====== Regulation S securities.-[62]- In the alternative, a non- U.S. investor with a valid exemption from registration can sell the Regulation S securities back into the United States upon expiration of the Regulation S holding period, which can span as little as 40 days. Thus, the securities placed outside the United States in reliance on Regulation S may be traded back into the United States, in some cases almost immediately, with no investor protection under the Securities Act for any subsequent purchasers in the United States. Recent press reports reveal another motive for offshore offerings.-[63]- Despite technical compliance with Regulation S's resale restrictions, some issuers reportedly have used the rule to effect an indirect illegal distribution to U.S. investors by, among other things, placing unregistered securities temporarily offshore to evade registration requirements.-[64]- Similarly, holders of restricted ---------FOOTNOTES---------- -[62]- Greene/Schneck Article, supra n.61, at 6. -[63]- See, e.g., Jaye Scholl, Easy Money: How Foreign Investors Profit at the Expense of Americans, An Invitation to Scamsters?, Barron's, April 29, 1996, at 31; Laurie Cohen, Rule Permitting Offshore Stock Sales Yields Deals That Spark SEC Concerns, Wall Street Journal, April 26, 1994, at C1; Linda C. Quinn, SEC Division of Corporation Finance Expresses Concern, INSIGHTS, April 1994, at 36. -[64]- As stated by the Commission in the recent release regarding problematic practices under Regulation S, it has come to the Commission's attention that some market participants are conducting placements of (continued...) ==========================================START OF PAGE 56====== securities have attempted to used the resale safe harbor of Regulation S to "wash" or remove the resale restrictions on those securities. The premise that the federal securities laws can be administered on a geographical basis is being further undermined by the ability of issuers to place offers on the Internet, which "shows no respect for those boundaries."-[65]- These developments have raised concerns regarding the effectiveness of the restrictions under Regulation S in policing the integrity of the Securities Act registration process. The effects of the merging of the public, private and offshore markets on the operation of the current Securities Act concepts and protections are grounds for significant concern. It seems clear that these concepts are no longer capable of achieving their purpose of protecting investors, and are imposing substantial costs on issuers. In the case of seasoned issuers, the benefits of attempting to preserve these distinctions are -[64]-(...continued) securities purportedly offshore under Regulation S under circumstances that indicate that such securities are in essence being placed offshore temporarily to evade registration requirements with the result that the incidence of ownership of the securities never leaves the U.S. market, or that a substantial portion of the economic risk relating thereto is left in or is returned to the U.S. market during the restricted period, or that the transaction is such that there was no reasonable expectation that the securities could be viewed as actually coming to rest abroad. Regulation S Release, supra n.48, [60 FR at 35664]. -[65]- Michael Salz, Small Stock Issuers Find a New Market on the Internet, Wall Street Journal, May 14, 1996 at 132 (quoting K. Robert Bertram, Pennsylvania Securities Commission). ==========================================START OF PAGE 57====== unclear, given the significant costs and reduced investor protection that comes from them. Rather, with regard to seasoned issuers, the Committee concluded that investor protection would be better served by a regulatory model that no longer attempts to preserve any artificial distinctions among these markets. Instead, the new regulatory model would provide for Securities Act protections for all sales to purchasers in the United States (regardless of whether the securities were first offered abroad), and would extend the type of discipline and quality of disclosure traditionally enjoyed by the primary markets to the company's continuous reporting, for the benefit of all the markets for the seasoned issuer's securities. C. Growth of Secondary Markets and Changes in Offering Techniques. Due to the explosive growth of trading in the secondary markets as compared to the primary issuance market, today most investors look to the Exchange Act for protection, rather than the Securities Act. As shown in Figure 2 in the Addendum to this Appendix A, with regard to common stock, the U.S. capital markets have shifted -- on a relative basis -- from a primary role as a source of capital to a venue predominantly for secondary trading. As shown in Figure 2, the secondary trading markets for common equity have grown exponentially in comparison to the primary issuance market, with over $5,500 billion in secondary trading versus $155 billion in primary issuances in 1995. The registered primary issuance market for ==========================================START OF PAGE 58====== common stock has remained relatively stagnant as a source of capital since 1933.-[66]- From a liability perspective, this shift is significant since the key liability provisions of the Securities Act offer protections only to purchasers of securities in the primary offering, not those purchasing an identical security in the secondary markets.-[67]- Moreover, since some believe Exchange Act reports "tend to be taken less seriously, and to be of lower quality," than documents prepared specifically for use in registered offerings,-[68]- the ultimate effect on ---------FOOTNOTES---------- -[66]- Figures 1 and 2 to the Addendum to this Appendix A. In addition, as shown in Figure 1, there has been a substitution in the primary markets of corporate debt for equity since 1983. -[67]- Although a secondary market purchaser who purchases securities that were originally registered under the Securities Act technically would be able to bring a claim under Section 11 of the Securities Act for material misstatements or omissions in the registration statement, the statute of limitations has begun to run with the initial sale by the issuer and such purchaser must be able to trace the securities purchased in the secondary market back to the original registration statement in order to maintain the Section 11 claim. Also, claims under Section 12(a)(2) of the Securities Act for material misstatements or omissions in the prospectus may only be brought against those in privity with the purchaser or who otherwise engage in soliciting activities. Pinter v. Dahl, 486 U.S. 622 (1988). -[68]- See Milton H. Cohen, The Integrated Disclosure System -- Unfinished Business, 40 Bus. Law. 987, 992 (1985) ("Cohen, Unfinished Business") (describing general agreement that the Exchange Act reports are not of the same quality as the Securities Act documents). Industry participants have informed the Committee staff that this (continued...) ==========================================START OF PAGE 59====== investor protection is potentially far-reaching for both the primary and secondary markets that price and function on the basis of those reports. Even when investors do participate in public offerings of securities, thereby receiving the protection of the Securities Act, the prospectus delivery and disclosure requirements have much less significance in the case of seasoned issuers because the company-related mandatory disclosure is incorporated by reference from the issuer's Exchange Act reports rather than physically delivered directly to purchasers. When Congress adopted the Securities Act in 1933, it envisioned that prospective investors would receive a single disclosure document containing all material information necessary to make an informed investment decision prior to making such decision.-[69]- Integrated disclosure and shelf registration have led to an ---------FOOTNOTES---------- -[68]-(...continued) conclusion is still valid today. See Transcript of July 26, 1995 Advisory Committee Meeting at 178 (statement of Roland Machold: "I used to write prospectuses myself and I can remember the first thing you did was throw away the 10-K and start from scratch. And I think that still goes on. The 10-K is filled out by clerks and the offering circular is filled out by people who have concerns"). See also Documents for Advisory Committee Meeting, September 29, 1995, Tab E (Letter dated August 1, 1995 from Robert S. Merritt, Chief Financial Officer, and Joseph J. Kadow, Vice President and General Counsel, Outback Steakhouse, Inc. to Brian T. Borders, President, Association of Publicly Traded Companies)(stating that Exchange Act disclosures could be improved). -[69]- See H.R. Rep. No. 85, 73d Cong., 1st Sess., at 8 (1933). ==========================================START OF PAGE 60====== increasing percentage of the primary issuances of securities by seasoned companies being made through the streamlined Form S-3 process,-[70]- where less of the disclosure mandated by the Securities Act is actually being delivered to investors. Instead, and appropriately, greater reliance is placed on the integrity of the Exchange Act reports to ensure a fair pricing of securities by repeat issuers. Recent rule changes adopted by the Commission to facilitate prospectus delivery in light of the movement to a three business day standard settlement time frame ("T + 3"),-[71]- and interpretive guidance issued by the Commission to assist issuers in the use of electronic rather than paper delivery of documents to investors under the federal securities laws,-[72]- preview the rapid changes occurring in the procedures used in securities offerings. Already, market participants are permitted to deliver the statutory prospectus information in more than one document. Also, such documents may be delivered to investors at ---------FOOTNOTES---------- -[70]- For information regarding the history of repeat issuances of common equity by seasoned issuers on Form S-3 over the last ten years, see Figure 4 in the Addendum to this Appendix A of the Report. -[71]- See Securities Act Rule 434 [17 C.F.R. 230.434], as adopted in Prospectus Delivery; Securities Transactions Settlements, Securities Act Rel. 7168 (May 11, 1995) [60 FR 26604 (May 17, 1995)]; Rule 15c6-1 [17 C.F.R. 240.15c6-1]. -[72]- See Use of Electronic Media for Delivery Purposes, Securities Act Rel. 7233, Exchange Act Rel. 36345 (October 6, 1995) [60 FR 53458 (October 13, 1995)]. ==========================================START OF PAGE 61====== separate intervals and in varying manners, including electronic delivery. Consequently, actual delivery of a final printed integrated prospectus to investors prior to or with the confirmation may soon become a relic of the past. As a result of these market and regulatory changes, the traditional transactional registration process may no longer be directly relevant to investors purchasing the securities of seasoned issuers. Since so much of the information deemed necessary for an investment decision is being provided through the public filing of Exchange Act reports with the Commission, the Committee believed that the original goals of the Securities Act would be better served by the adoption of new disclosure practices and procedures that should have the beneficial effect of focusing the participants in the capital formation process on enhancing the quality of the disclosure in these reports. D. Changes in Gatekeeper Role. According to Milton H. Cohen, the superiority of Securities Act disclosure is related directly to the "in terrorem" effect of the statutory liability provisions of the Securities Act on the issuer's directors, underwriters, accountants, and other gatekeepers charged with responsibility for the issuer's disclosure in connection with a public offering.-[73]- Under the traditional offering process, ordinarily there would be ample time available before the filing of a registration statement, and again before ---------FOOTNOTES---------- -[73]- See Cohen, Unfinished Business, supra n.68, at 989. ==========================================START OF PAGE 62====== effectiveness of that registration statement, for these gatekeepers to exercise their investigatory responsibilities. The lead underwriter normally participates in the drafting of the registration statement and undertakes significant investigation of the company, its business and its management in connection with an offering. This due diligence obligation has developed largely in response to the underwriter's exposure to liability for false or misleading disclosures in the registration statement. Supporters of the current liability system point out that it imposes policing responsibilities on those parties best equipped to judge the accuracy and completeness of registration disclosures. This disincentive to carelessness created by the liability structure ultimately benefits investors and the markets as a whole. Many in the underwriting and legal communities believe that it has become increasingly difficult for underwriters to discharge their due diligence responsibility in the context of the streamlined offering process afforded by integrated disclosure and shelf registration. According to a recent report on due diligence by the American Bar Association's Task Force on Due Diligence,-[74]- the informational convergence between the Securities Act and the Exchange Act as a result of integrated ---------FOOTNOTES---------- -[74]- American Bar Association Committee on Federal Regulation of Securities, Report of the Task Force on Sellers' Due Diligence and Similar Defenses Under the Federal Securities Laws, 48 Bus. Law. 1185 (May 1993). ==========================================START OF PAGE 63====== disclosure, and the severe time constraints imposed by shelf registration, make it difficult, if not impossible, for underwriters in a shelf takedown to perform a traditional, in- depth due diligence analysis of the issuer, especially since the bulk of the required company-related disclosure will be satisfied through incorporation by reference. Underwriters claim to be hampered in their due diligence efforts because they typically do not help prepare the issuer's Exchange Act reports.-[75]- Thus, with respect to seasoned issuers using the shelf process, the current system may be suffering from an erosion of the underwriter's traditional performance of due diligence, one of the key safeguards against fraud under the Securities Act liability paradigm. With the increasing use of the shelf process to conduct offerings of equity securities, the difficulties highlighted in the ABA Due Diligence Report may become further exacerbated. This trend is evidenced by recent reports of large takedowns of common equity off a universal shelf being directly placed in what are essentially block trades, as contrasted with the usual underwritten offering approach.-[76]- Underwriting firms ---------FOOTNOTES---------- -[75]- Documents for Advisory Committee Meeting, November 21, 1995, Tab E (Letter dated November 2, 1995 from the Securities Industry Association to the Advisory Committee, at 5-7)(the "SIA Letter"). -[76]- Santoli, supra n.9 ("efforts to sell stock directly are another sign of Wall Street's eroding role as gatekeeper and disseminator of information, a process that gathers force with each new application of communications technology (continued...) ==========================================START OF PAGE 64====== assert that the shift in the focus of disclosure to the periodic reports filed under the Exchange Act, as well as the streamlining of the registration process through the adoption of shelf registration, without a commensurate change in the statutory liability structure or the gatekeeper function, is fundamentally unfair and should be addressed.-[77]- Members of the board of directors likewise may have cause for concern under the current liability scheme. Substantial portions of the Securities Act disclosure requirements are now being satisfied with information incorporated by reference from Exchange Act periodic reports. Board members do not tend to pay as much attention to the preparation of information in a company's periodic reports as they would if such information was being prepared directly for a public offering document.-[78]- Nor are board members positioned to review either the Exchange Act filings or offering documents in an environment of frequent offerings conducted with minimal advance ---------FOOTNOTES---------- -[76]-(...continued) to the investment business"). -[77]- SIA Letter, supra n.75, at 7-10. -[78]- See Transcript of May 8, 1995 Advisory Committee Meeting at 166 (statement of Mr. Roland M. Machold). See also Joseph McLaughlin, Integrated Disclosure, Shelf Registration and Other Due Diligence Challenges in the Public Offering Process, PLI CONDUCTING DUE DILIGENCE 1995 (March 14, 1995), at 2. ==========================================START OF PAGE 65====== planning and little opportunity for a due diligence review.-[79]- Finally, the increased significance of the secondary markets is cause to question the wisdom of focusing the gatekeeper function on episodic transactions. Indeed, a significant portion of the reporting companies whose securities are actively traded ---------FOOTNOTES---------- -[79]- During the February 22, 1996 Advisory Committee meeting, Professor Coffee gave the following "illustrations:" I had a conversation [with an outside director] on the board of a company that has been, for the last six months, making daily sales of its equity securities to an underwriter through universal shelf registration. His problem, as he said throwing up his hands, is there is no way in the world that we can conduct daily due diligence. There is nothing in the system that tells us how we can do it or what we can do to comply with this kind of world. He went on to describe to me a case ... of a very major insurance company that has been told by its underwriters that it would be very attractive to it to be able to use the underwriter to make daily small sales in a manner that would not move the market. Again, selling equity securities through the market maybe three or four times a week in small quantities, but the board of directors and the lawyers of that large insurance company are very, very concerned that kind of process of constant sales would expose the directors to difficulties because there would be no way that they could, on a constant basis, fulfill their due diligence responsibilities. Transcript of February 22, 1996 Advisory Committee Meeting at 51-52. Professor Coffee observed that one of the intended effects of company registration -- small, frequent equity offerings not planned very many days in advance -- would present the same concerns. Id. at 52. ==========================================START OF PAGE 66====== in the public markets never access these markets for new capital.-[80]- Consequently, apart from the important discipline of the annual audit, these companies are never subjected to the type of investigation by others contemplated by the Securities Act. The company registration system, by contrast, will help alleviate some of these concerns by permitting and encouraging more and better due diligence by those in the position to be most knowledgeable, without lowering liability standards. By providing incentives and mechanisms for increased and enhanced ongoing oversight of a company's disclosures to the market, and by requiring all material development disclosure, including transactional disclosure, to be filed as part of the registration statement at the time of the offering, investor confidence in both the primary and secondary trading markets should be heightened, thereby ultimately lowering a company's cost of capital. * * * The increasing inapplicability of traditional transactional registration concepts in today's undifferentiated markets, the growth of the secondary markets, the regulatory shift to reliance on Exchange Act reports, as well as the persistent concerns with the quality of that disclosure and adequacy of gatekeeper due ---------FOOTNOTES---------- -[80]- See Figure 4 in the Addendum to this Appendix A of the Report (only 4-6% of NYSE, AMEX and Nasdaq companies made underwritten offerings of additional common stock each year since 1985). ==========================================START OF PAGE 67====== diligence in the context of today's expedited offering process, all point to the conclusion that the existing Securities Act protections and processes needed to be re-examined. Investor protection and capital formation would be better served by a regulatory system that operates to improve the quality and reliability of a company's continuous disclosure while eliminating costly transactional registration requirements and restrictions that no longer serve to protect investors. Improved disclosure can be accomplished in a number of ways, including by having senior management and the board of directors focus on and improve the procedures under which the company's reports are prepared, and through the adoption of measures to ensure more timely disclosure of significant developments, as well as through greater auditor involvement. Measures to reorder and rationalize the gatekeeper and monitor function to focus on the integrity of the company's reports on an ongoing, rather than an episodic basis, will preserve and reinforce the protections afforded by outside oversight of a company's disclosures.