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SEC AMENDS RULE 504 OF
REGULATION D
As part of the Securities and Exchange Commission's (SEC)
efforts to deter fraudulent microcap activity in the over-the-counter (OTC) secondary
market, effective April 7, 1999, the SEC amended Rule 504 of Regulation D. The amendments
limit Rule 504 general solicitation and the issuance of freely tradable
securities to transactions:
(1) registered under state law requiring
public filing and delivery of adisclosure document to investors before sale, or;
(2) exempted under state law permitting general solicitation
and advertising so long as sales are made only to accredited investors.
A BIT OF HISTORY
In 1980, Congress passed the Small Business Investment
Incentive Act (SBII Act) to reduce the regulatory restraints on small business capital
formation. The SBII Act added Section 4(6) of the Securities Act of 1933 ("Securities
Act"), which exempted from federal registration offers or sales of securities in the
aggregate amount of $5 million or less if solely made to accredited
investors. In 1982, the SEC adopted Regulation D, providing exemptions from Securities
Act registration for securities offerings under Rules 504, 505 and 506. In a
nutshell, Rule 504 provides an exemption for the limited offering and sales of securities
not exceeding $1 million in a 12-month period.
ACCREDITED INVESTOR
As defined in pertinent part under Rule 501(a) of Regulation D (Rules 501-508), an
Accredited Investor shall mean any person who comes within any of the following
categories, or who the issuer reasonably believes comes within any of the following
categories, at the time of the sale of the securities to that person. . .(4) Any director,
executive officer, or general partner of the issuer of the securities being offered or
sold, or any director, executive officer, or general partner of a general partner of that
issuer; (5) Any natural person whose individual net worth, or joint net worth with that
person's spouse, at the time of his purchase exceeds $1,000,000; (6) Any natural person
who had an individual income in excess of $200,000 in each of the two most recent years or
joint income with that person's spouse in excess of $300,000 in each of those years and
has a reasonable expectation of reaching the same income level in the current year; . . |
MOTIVATION
In calendar year 1998, there were 2,988 Forms D filed by
2,499 companies with the SEC claiming the Rule 504 exemption. Unfortunately, the SEC
perceives that companies characterized by thin capitalization, low share prices, limited
public information and little or no analyst coverage - - - so-called "microcap"
companies - - -have become a fertile ground for fraud. . The SEC is worried that what was
once an exemption intended for a non-reporting issuer offering
securities locally, has now been transformed through the Internet as an exemption for a
nationwide offering; and has all too frequently been used to fraudulently promote microcap
companies.
NON-REPORTING ISSUER
A non-reporting issuer is an issuer that is not required to file reports with the
Commission under Section 13 or 15(d) of the Securities Exchange Act of 1934
("Exchange Act). |
PUMP AND DUMP
The SEC has expressed concern over the increased use of
Rule 504 in microcap pump and dumpschemes. In furtherance of this fraud,
prearranged "sales" of Rule 504 securities are made to nominees in states that
do not have registration or prospectus delivery requirements. Next, these securities are
placed with broker-dealers who generally use high-pressure cold-calling techniques to sell
the securities at ever-increasing prices to unknowing investors. When the selling
broker-dealers' inventory is exhausted, these firms permit the artificial market demand
they stimulated to collapse, and investors lose much, if not all, of their investment.
REG D'S INITIAL-SALES-ONLY LIMITATION
Regulation D is only available for offers and sales by an
issuer of securities to initial purchasers; it is not available to any affiliate of the
issuer or to any person for resales of the securities. Thus,
purchasers of Rule 504 securities wishing to sell these securities, must either register
the transaction or have an exemption for the transaction. Furthermore, purchasers of such
securities with a view to their distribution are acting as underwriters
and thus their sales of the securities are not exempt from registration. Regulation D is
not available to any issuer for any transaction or chain of transactions that, although in
technical compliance with the rules, is part of a plan or scheme to evade the registration
provisions of the Securities Act. In such cases, registration is required.
| The
"resale" exemption of Section 4(1) of the Securities Act is unavailable since
the exemption is available to "any person other than an issuer, underwriter
or dealer." The dealer exemption of Section 4(3) of the Securities Act also is
unavailable where the person relying upon the exemption acts as an
"underwriter." |
| An
"underwriter" is defined in Section 2(a)(11) of the Securities Act to include
"any person who has purchased from an issuer with a view to, or offers or sells for
an issuer in connection with, the distribution of any security, or participates or has a
direct or indirect participation in any such undertaking, or participates or has a
participation in the direct or indirect underwriting of any such undertaking...." |
THE AMENDMENT
Amended Rule 504 restricts and prohibits general
solicitation and general advertising, unless the following specified conditions permitting
a public offering are met:
- the transactions are registered under a state law requiring
public filing and delivery of a disclosure document before sale. For sales to occur in a
state without this sort of provision [at present, only New York and the District of
Columbia], the transactions must be registered in another state with such a provision and
the disclosure document filed in that state must be delivered to all purchasers before
sale in both states; or
- the securities are issued under a state law exemption that
permits general solicitation and general advertising so long as sales are made only to
"accredited investors" as that term is defined under Rule
501(a) of Regulation D.
WARNING!!
With respect to Rule 504 offerings that are ongoing as of April 7, 1999, issuers will have
to discontinue offers and register under a state law requiring the preparation and
delivery of a disclosure document to investors before sale in order to issue freely
tradable securities. |
For Further Reference:
See, SEC release 33-7644; S7-14-98.
Richard K. Wulff or Barbara C. Jacobs (202-942-2950), Office of Small Business, Division of Corporation Finance, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. |
