[Federal Register Volume 63, Number 102 (Thursday, May 28, 1998)]
[Proposed Rules]
[Pages 29168-29174]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-14024]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 230

[Release No. 33-7541; S7-14-98]
RIN 3235-AH35


Revision of Rule 504 of Regulation D, the ``Seed Capital'' 
Exemption

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rules.

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SUMMARY: Rule 504 of Regulation D provides an exemption from Securities 
Act registration when non-reporting issuers make securities offerings 
that do not exceed an aggregate annual amount of $1 million. These 
offerings are not reviewed by the Commission. Instead, state securities 
regulation plays an important role in the oversight of these 
transactions. Securities sold under Rule 504 are generally freely 
tradable except by affiliates. Based on recent reports from the 
Commission's examination and enforcement programs, it appears that the 
freely tradable nature of these securities may have facilitated some 
later fraudulent secondary transactions in the over-the-counter markets 
for securities of ``microcap'' companies. In light of this use, Rule 
504 may need to be strengthened. Therefore, we are publishing for 
comment proposed amendments to eliminate the freely tradable nature of 
securities issued under Rule 504.

DATES: Comments should be received on or before July 27, 1998.

ADDRESSES: Please send three copies of the comment letter to Jonathan 
G. Katz, Secretary, U.S. Securities and Exchange Commission, Mail Stop 
6-9, 450 Fifth Street, N.W., Washington, D.C. 20549. Comments also may 
be submitted electronically to the following e-mail address: <a href="/cdn-cgi/l/email-protection#087a7d646d25026b6765656d667c7b487b6d6b266f677e">rule-
<span class="__cf_email__" data-cfemail="eb888486868e859f98ab988e88c58c849d">[email protected]</span></a>. All comment letters should refer to File Number S7-
14-98; this file number should be included on the subject line if e-
mail is used. Anyone can inspect and copy the comment letters in our 
public reference room at 450 Fifth

[[Page 29169]]

Street, N.W., Washington, D.C. 20549. We will post comment letters 
submitted electronically on our Internet Web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT: Richard K. Wulff or Barbara C. Jacobs, 
Office of Small Business, Division of Corporation Finance, at (202) 
942-2950.

SUPPLEMENTARY INFORMATION:

I. Executive Summary

    Over the years, Congress has passed significant legislation to aid 
small businesses in raising capital in the private and public 
securities markets. The Small Business Investment Incentive Act of 
1980, for example, was designed to reduce the regulatory restraints on 
small business capital formation.<SUP>1</SUP> In response to that Act, 
the Commission adopted Regulation D <SUP>2</SUP> under the Securities 
Act of 1933 (``Securities Act'') <SUP>3</SUP> in 1982.<SUP>4</SUP> Rule 
504 of Regulation D is the limited offering exemption designed to aid 
small businesses raising ``seed capital.'' Currently, it allows a non-
reporting issuer <SUP>5</SUP> to offer and sell securities to an 
unlimited number of persons. The exemption is not conditioned on the 
sophistication or experience of the investors or on delivery of any 
specific information to them. General solicitation and general 
advertising are permitted for all Rule 504 offerings. However, the 
offering price for a Rule 504 offering, aggregated with certain other 
offerings, may not exceed $1 million within a 12-month 
period.<SUP>6</SUP> Securities sold under the exemption may be resold 
freely by non-affiliates of the issuer.<SUP>7</SUP>
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    \1\ Pub. L. No. 96-477, 94 Stat. 2275. That Act amended the 
Securities Act by adding Section 4(6) [15 U.S.C. 77(d)(6)] which, 
among other matters, exempts from registration offers or sales of 
securities in the aggregate amount of $5 million or less if solely 
made to ``accredited investors.''
    \2\ 17 CFR 230.501 et seq. Regulation D provides three separate 
securities offering exemptions from Securities Act registration: 
Rules 504, 505 and 506. Rule 505 is a limited offering exemption for 
non-public offerings of up to $5 million. It is designed to help 
small businesses because it permits sales to a small number of 
nonaccredited, unsophisticated investors. It also was created to 
coordinate with the North American Securities Administrators 
Association, Inc. (``NASAA'') Uniform Limited Offering Exemption 
(``ULOE''). Rule 506 is the Commission's safe harbor rule 
promulgated under the ``non-public'' offering exemption of Section 
4(2) [15 U.S.C. 77d(2)]. It permits private sales only to accredited 
investors and a limited number of sophisticated investors.
    \3\ 15 U.S.C. 77a et seq.
    \4\ See Release No. 33-6389 (March 8, 1982) [47 FR 11251].
    \5\ A non-reporting issuer is an issuer that is not subject to 
the reporting requirements of Section 13 or 15(d) of the Securities 
Exchange Act of 1934 [15 U.S.C. 78a et seq.]. Other issuers that are 
ineligible to use Rule 504 include investment companies and 
development stage companies that either have no specific business 
plan or purpose or have indicated that the business plan is to 
engage in a merger or acquisition with an unidentified company or 
companies, or other entity or person. See Rule 504(a) of Regulation 
D.
    \6\ Rule 504 offerings are aggregated for this purpose with all 
other offerings exempt pursuant to Section 3(b) (e.g., Rule 504 or 
505 offerings) and all offerings made in violation of Section 5(a) 
of the Securities Act [15 U.S.C. 77e(a)].
    \7\ See interpretive letter to Mr. E.H. Hawkins (June 26, 1997), 
setting forth the views of the Division of Corporation Finance that 
affiliates who receive securities in a Rule 504 offering are subject 
to resale restrictions.
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    Issuers using Regulation D must find exemptions or register in 
every state in which they offer the securities. The vast majority of 
states require registration of Rule 504 offerings.<SUP>8</SUP> In 
enacting Rule 504, the Commission tacitly deferred primary regulatory 
responsibility to state securities administrators because the size and 
local nature of these small offerings did not appear to warrant the 
imposition of extensive federal regulation.<SUP>9</SUP> These offerings 
continue, however, to be subject to federal antifraud and other civil 
liability provisions.
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    \8\ Rule 504 is not a part of ULOE. Connecticut, Delaware and 
Oklahoma have exemptions that directly coordinate with Rule 504. See 
J.W. Hicks, 7A Exempted Transactions under the Securities Act of 
1933, Section 7.09[3](1997).
    \9\ As with all Regulation D offerings, a Form D is required to 
be filed with the Commission no later than 15 days after the first 
sale in the Rule 504 offering. See Rule 503 [17 CFR 230.503]. Filing 
a Form D is not, however, a condition to the exemption.
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    Despite the protective limitations built into the exemption by the 
Commission, it appears that securities issued under Rule 504 have been 
used to facilitate a number of fraudulent secondary transactions 
through the OTC Bulletin Board operated by the National Association of 
Securities Dealers, Inc. (``NASD'') or the ``pink sheets'' published by 
the National Quotation Bureau, Inc.<SUP>10</SUP> These offerings have 
generally involved the securities of ``microcap'' companies, i.e., 
those characterized by thin capitalization, low share prices, and 
little or no analyst coverage. While we believe that the scope of abuse 
is small in relation to the actual usage of the exemption,<SUP>11</SUP> 
we also believe that a regulatory response may be 
necessary.<SUP>12</SUP> Therefore, we are proposing to implement the 
same resale restrictions on securities issued in a Rule 504 transaction 
as apply to transactions under the other Regulation D 
exemptions.<SUP>13</SUP> In this way, we believe that unscrupulous 
stock promoters will be less likely to use Rule 504 as the source of 
the freely tradable securities they need to facilitate their fraudulent 
activities in the secondary markets.
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    \10\ See, e.g., Schroeder, ``Penny Stock Fraud is Again on a 
Resurgence, Bolstered by Loopholes and New Technology,'' Wall St. 
J., September 4, 1997, at 12.
    \11\ The Commission's records indicate that approximately 1500 
Forms D have been filed under Rule 504 in each of the past several 
years. NASD officials believe that between 300 to 500 applications 
for OTC Bulletin Board quotations were based upon the Rule 504 
exemption in each of those years.
    \12\ These proposals are part of the our comprehensive agenda to 
deter registration and trading abuses, particularly by ``microcap'' 
issuers. The Commission has developed a four-pronged approach to 
minimize ``microcap fraud': enforcement, investor education, 
compliance examinations, and regulation.
    The Commission issued three releases on February 17, 1998 to 
address this abuse. See Securities Act Release No. 7505, adopting 
amendments to Regulation S [17 CFR 230.901 et seq.]; Securities Act 
Release No. 7506, proposing amendments to restrict the use of Form 
S-8 for sales to consultants and advisors; and Exchange Act Release 
No. 39670, proposing amendments to Exchange Act Rule 15c2-11 [17 CFR 
240.15c2-11] to require all broker-dealers to obtain and review 
enhanced information about certain issuers when they first publish 
(or resume publishing) a quotation for a security.
    \13\ Securities issued in a Rule 504 transaction would be 
defined as ``restricted securities'' as the term is defined in Rule 
144(a)(3) [17 CFR 230.144(a)(3)]. The Commission has not observed 
the same level of fraudulent secondary trading in securities issued 
pursuant to Rules 505 and 506, which are restricted. This 
observation suggests that restricting resale may deter abuse. The 
Commission requests data and analysis from commenters on whether 
these rules are being abused.
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    While this change also will have some impact upon small businesses 
trying to raise ``seed capital'' in bona fide transactions, we believe 
that effect is justified in light of the circumstances. Without action 
to hinder the use of securities issued under Rule 504 for fraudulent 
purposes, small businesses could be unfairly impacted by the taint that 
might attach to Rule 504 offerings. Moreover, to minimize the impact, 
we would continue to allow public solicitation and unrestricted use of 
public advertising to aid small businesses in their search for 
investors.

II. Background of Rule 504

    Before the 1992 amendments, Rule 504 provided a different exemptive 
scheme than the current rule does. Former Rule 504 exempted public 
offerings if sales did not exceed $1 million <SUP>14</SUP> in a 12-
month period and if the offering was registered with one or more states 
that required the preparation and delivery of a disclosure document to 
investors before sale.<SUP>15</SUP>

[[Page 29170]]

Private offerings, in which general solicitation and general 
advertising were prohibited, were exempted if sales did not exceed 
$500,000. State registration was not a condition to the exemption in 
the private context.
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    \14\ As originally adopted in 1982, the exemption was subject to 
a $500,000 limitation. In 1988, the ceiling for public offerings was 
increased to $1 million. See Release No. 33-6758 (March 3, 1988) [53 
FR 7866].
    \15\ Form U-7 (also referenced as ULOR, uniform limited offering 
registration, or SCOR, small corporate offering registration), which 
was developed by NASAA and the American Bar Association, is a 
special registration format for companies registering securities 
under state securities laws when relying upon Rule 504. See Harris, 
Keller, Stakias & Liles, Financing the ``American Dream,'' 43 
Business Lawyer 757 (1988). As of October 1997, Form U-7 has been 
either formally adopted or recognized and accepted by 40 states.
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    In July 1992, the Commission adopted revisions to its rules and 
forms to further facilitate capital raising by small 
businesses.<SUP>16</SUP> The amendments eliminated all restrictions on 
the manner of offering and on resales under Rule 504. As a result, a 
non-reporting company could offer up to $1 million of securities in a 
12-month period and be subject only to the antifraud and other civil 
liability provisions of the federal securities laws. General 
solicitation and general advertising were permitted for all Rule 504 
offerings. Further, securities sold under Rule 504 were not deemed 
``restricted securities'' and thus were available for immediate resale 
by non-affiliates of the issuer, as long as the non-affiliates were not 
``underwriters'' <SUP>17</SUP> of the offering.<SUP>18</SUP>
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    \16\ See Release No. 33-6949 (July 30, 1992) [57 FR 36442]. On 
April 28, l993, the Commission adopted additional revisions to 
facilitate still further financings by small business issuers. See 
Release No. 33-6996 (April 28, 1993) [58 FR 26509].
    \17\ Section 2(a)(11) of the Securities Act [15 U.S.C. 
77b(a)(11)].
    \18\ Regulation D exemptions are available only to the issuer of 
the securities. None of these exemptions can be used by any other 
person. Preliminary Note 4 to Regulation D.
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    In revising the exemption in 1992, the Commission sought to balance 
the needs of investors and the needs of small business. In the years 
that have elapsed since Rule 504 was revised, the capital markets have 
experienced unprecedented growth.<SUP>19</SUP> The strong markets have 
given rise to more widespread trading of securities in non-reporting 
companies in interdealer quotation systems such as the OTC Bulletin 
Board. Moreover, since 1992, market innovations and technological 
changes--most notably, the Internet--have created the possibility of 
nationwide markets for these exempt securities that were once thought 
to be sold only locally. The combination of these factors, the lack of 
widely-distributed public information about companies making Rule 504 
offerings and the freely tradable nature of Rule 504 securities may 
have exacerbated the opportunities for microcap fraud.
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    \19\ In 1992, the Dow Jones Industrial Average, a price-weighted 
average of 30 actively-traded stocks listed on the New York Stock 
Exchange, was at 3000; it recently passed the 9000 mark. Other 
indicators similarly demonstrate the overall growth of the 
securities markets. For example, during the same period, the Russell 
2000 small stock index, a measure of the stock performance of small 
company stocks, moved from 200 to a recent close of over 490.
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    There have been a significant number of recent Commission 
examinations of broker/dealers and enforcement investigations with 
allegations of fraud involving microcap companies.<SUP>20</SUP> Some of 
these matters involve transactions where a company sold securities in 
reliance upon Rule 504 to certain persons who then manipulated the 
price of the securities to defraud unknowing investors. While the 
initial Rule 504 sales have not necessarily been fraudulent, the 
Commission is concerned that the current Rule's flexibility, which 
permits general solicitation of investors, contains no disclosure 
requirements, and allows free transferability of issued securities, is 
being abused by perpetrators of microcap fraud.
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    \20\ The National Association of Securities Dealers, Inc. (NASD) 
also has recently proposed a series of measures to address microcap 
fraud. See, e.g., OTC Bulletin Board Quotations Rule Amendments 
(NASD Notice to Members 98-14) (Rule 6530 and Rule 6540).
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    In some cases, those who prey on investors through fraudulent 
schemes make prearranged ``sales'' of securities under Rule 504 to 
nominees in states that do not have registration or prospectus delivery 
requirements. As a part of this arrangement, these securities are 
subsequently placed with broker-dealers who use cold-calling techniques 
to sell the securities at ever-escalating prices to unsuspecting 
investors. When their inventory of shares has been exhausted, these 
firms permit the artificial market demand they have created to 
collapse, causing investors to lose much, if not all, of their 
investment.<SUP>21</SUP>
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    \21\ This technique is sometimes colloquially referred to as 
``pump and dump.''
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    While Rule 504 is not essential to such a microcap fraud, its 
limited compliance requirements provide an attractive device for stock 
manipulators to generate a large pool of securities for use in 
manipulation schemes. If the microcap market, or offerings under Rule 
504, become stigmatized as unsavory, legitimate small businesses may 
become less able to raise money as investors lose confidence in the 
market and in the integrity of those making such offerings. To prevent 
that from happening, the Commission is reevaluating the Rule and the 
revisions to it adopted in 1992.

III. Proposed Revisions

    In order to discourage abuse of those provisions of the Rule 504 
exemption that unscrupulous stock promoters apparently find attractive 
and yet preserve the usefulness of the exemption for small business, 
the Commission proposes to impose resale restrictions on securities 
issued pursuant to the provision. Under the proposal, all securities 
issued under Rule 504 would constitute ``restricted securities'' as the 
term is used in Rule 144. Consequently, these securities could only be 
resold: (1) After the one-year holding period imposed by Rule 144, (2) 
through registration, or (3) through another exemption (such as 
Regulation A<SUP>22</SUP>), if available.
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    \22\ 17 CFR 230.251 et seq.
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    This approach would be consistent with the other Regulation D 
exemptions and other types of offerings not registered with us. While 
it typically prevents investors from reselling the securities in less 
than a year, it also discourages the use of the securities as a part of 
a fraud or manipulation during the same period. It encourages longer 
term investment and may provide the necessary time for the market to 
learn more about the small issuer, which are beneficial factors for the 
investor and the issuer as well.
    The Commission requests comments on the effect of this proposal 
upon the abuses we have described in the microcap market. If commenters 
believe that the proposal will not have the desired prophylactic 
impact, they should explain the bases for their views and indicate 
their views of the problem, the appropriate manner of rectifying it and 
data supporting their views.
    In developing our recommendations, we always try to determine 
whether the proposed regulatory actions will unduly burden legitimate 
small businesses. We keep in regular contact with small business 
representatives. Based upon our ongoing dialogue, we believe that 
today's proposals are sufficiently measured so that the most useful 
aspects of Rule 504 would be preserved. We have found that small 
business representatives share our concern about the harmful presence 
of those who would taint the microcap market and therefore raise the 
cost of raising capital for legitimate small businesses. We 
specifically seek the views of the small business community on the 
proposals.<SUP>23</SUP>
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    \23\ The Commission hosts town hall meetings across the country 
from time to time for small business to discuss issues like the 
Commission's capital formation rules. These meetings are instructive 
about the current concerns and problems facing small businesses in 
raising capital in the securities markets, and permit us to design 
programs that will meet their needs consistent with the protection 
of investors. In future sessions, we intend to discuss our proposals 
with attendees and encourage them to submit their views as a part of 
this rulemaking proceeding. In addition, the University of Southern 
California recently sponsored a forum at which a number of issues 
important to small business, including alleged abuses that are the 
basis for our proposal, were discussed and considered by a group of 
small business representatives and Commission staff.

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[[Page 29171]]

IV. Other Possible Approaches to Rule 504 Reform

    The Commission seeks comments on whether it should adopt other 
amendments to Rule 504, in addition to or in lieu of those discussed in 
this release, to discourage its abuse while preserving its utility for 
small businesses.
    The Commission is particularly interested in hearing from 
commenters about whether general solicitation and advertising should 
continue to be permitted in Rule 504 offerings, and whether the lack of 
restrictions in this area have been a source of abuse, particularly in 
finding investors or generating market interest in issuer securities. 
If general solicitation and general advertising is thought to be 
connected to abusive situations, commenters should recommend how these 
abuses might be deterred. For example, should the Commission 
reintroduce the requirement that general solicitation and general 
advertising of securities offered under Rule 504 be conditioned in some 
way? Under one model, public offerings under the Rule 504 exemption 
might be limited to where the issuer complies with state registration 
processes that require the preparation and delivery of a disclosure 
document to investors prior to sale of the securities. Should general 
solicitation and general advertising be contingent upon state 
registration and prospectus delivery to all investors before sale? 
Would adding these requirements further discourage fraudulent secondary 
market activity as well as fraudulent offerings under Rule 504? If so, 
would the cost to small businesses of restricting the solicitation 
methods permitted by Rule 504 be outweighed by the benefits from 
avoiding a taint to Rule 504? How should offerings made pursuant to 
certain state exemptions, such as the one recently developed for sales 
to ``accredited investors,'' \24\ be treated? Under this model (which 
was the rule before 1992), private offerings would continue to be 
permitted without compliance with this particular type of state 
registration procedure. Should all provisions of the previous version 
of the rule be reinstituted, i.e., should publicly offered securities 
issued under the exemption be unrestricted?
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    \24\ State exemptions of this nature include those based upon 
the ``Model Accredited Investor Exemption,'' which was adopted by 
NASAA in 1997. CCH NASAA Reporter Paragraph 361. Generally, the rule 
exempts offers and sales of securities from state registration 
requirements, if among other matters, the securities are sold only 
to persons who are, or are reasonably believed to be, ``accredited 
investors'' as defined in Rule 501(a) of Regulation D. Written 
solicitations under that provision are generally limited to a type 
of ``tombstone'' ad. To date, 11 states have adopted the exemption.
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    The Commission also is particularly interested in hearing from 
commenters about the absence of specific disclosure requirements under 
Rule 504, as contrasted to offerings under Rules 505 and 506, which 
must satisfy the information requirements of Rule 502(b) of Regulation 
D.\25\ Should the Commission require that a disclosure document 
satisfying those information requirements be delivered to non-
accredited investors before sale in Rule 504 offerings? To ensure easy 
access for all investors, should disclosure documents and other sales 
materials be required to be provided as an exhibit to the Form D? Since 
Forms D are not currently filed electronically with the Commission, 
should a change be made requiring electronic filing? Should these 
documents be provided to the Commission for its information only? What 
issues would this type of procedure raise under the Freedom of 
Information Act \26\? Should a confidential treatment process be 
developed to protect some of the information contained in these 
documents?
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    \25\ 17 CFR 230.502(b).
    \26\ 5 U.S.C. 552.
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V. Solicitation of Comment--Other Rule 504 Improvements

    The Commission seeks comment with respect to each of the other 
facets of the current Rule 504 regulatory compliance scheme. 
Specifically, does the current Rule serve investors' interests? If not, 
how could this Rule be further strengthened? Should a lower aggregate 
dollar amount, such as $500,000, be implemented with different 
requirements in order to provide a more effective compliance system? 
Should the current 12-month measuring period be lengthened to 2 years, 
with or without a change in the aggregate dollar limitation?
    Should the types of issuers eligible to use the exemption be 
changed? For example, should particular types of ``penny stock'' issues 
be excluded, e.g., offerings for less than $1 per share? Should issuers 
with total assets or market capitalization below a minimum amount be 
precluded from using the rule, e.g., $1 million? Would such a limit be 
consistent with a stated purpose of the exemption: for raising ``seed 
capital''?
    Does the current rule serve issuers' needs? At the same time we are 
proposing to tighten the rule, are there other areas of the Rule that 
we can modify to provide small businesses with flexibility without 
compromising investor protection? For example, should the measuring 
period for determining the scope of an offering be shortened to six 
months? Should the dollar limitation in the Rule be increased to $5 
million or some higher dollar amount if accompanied with additional 
compliance requirements such as specified disclosure requirements or 
state registration requirements? \27\
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    \27\ See NASAA's Report of the Task Force on the Future of 
Shared State and Federal Securities Regulation (October 1997). The 
Task Force, among other matters, recommended that the Commission 
raise the offering amount in Rule 504 offerings to $10 million 
pursuant to its new authority under Section 28 of the Securities Act 
[15 U.S.C. 77z-3]. It also recommended that offerings made in an 
amount over $1 million be required to be registered in the states 
where the offering is made.
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    Do differences in state registration schemes affect the utility of 
Rule 504? Do those differences affect the incidence of fraudulent 
secondary trading? If so, how? Has reliance on state regulation 
achieved the goals set out by the Commission when it amended Rule 504 
in 1992? \28\ Although improving, has the lack of uniformity of state 
securities regulation in this area had any impact on Rule 504 
offerings? Should Rule 504 be revised to impose greater uniformity 
nationwide in disclosures provided to investors under Rule 504? Should 
public offerings under Rule 504 be limited to only those offerings 
registered in and made in states participating in NASAA's regional 
review program? \29\
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    \ 28\ See note 16 above.
    \ 29\ NASAA and a number of states have developed regional 
review procedures that permit an issuer to file in each state, but 
to indicate with the filing that regional review is requested. Under 
those circumstances, the issuer will receive only one set of 
comments, and the filing can become effective simultaneously in all 
states in the region in which filings have been made. To date, the 
regional system has been set up in the following areas: Western 
States (Alaska, Arizona, California, Colorado, Idaho, Oregon, Utah 
and Washington); New England States (Connecticut, Maine, 
Massachusetts, New Hampshire, Rhode Island, and Vermont); and 
Midwestern States (Illinois, Indiana, Iowa, Kansas, Michigan, 
Missouri, and Wisconsin).
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    Should the Commission take a more active role in monitoring Rule 
504 transactions to ensure compliance with the antifraud requirements 
of the federal securities laws? Should additional information be 
mandated in Form D?

[[Page 29172]]

For example, should Form D be required to indicate the state(s) where 
the offering was made? Or, should Form D filers be required to amend 
their filings periodically (whether quarterly, annually or some other 
increment of time) to disclose: (1) Whether they have prepared or 
provided information to facilitate trading such as the NASD's Form 211, 
which is required prior to inclusion on the OTC Bulletin Board; and (2) 
whether they have provided other information to potential or existing 
market makers for their securities?
    Before the adoption of Rule 701,\30\ the Rule 504 exemption was 
used by a number of foreign private issuers in order to compensate 
their U.S. employees by issuing them company securities. Many of these 
issuers had substantial market capitalizations and were listed on 
foreign exchanges. Comment is requested concerning the impact of the 
proposed revisions upon these companies. Specifically, is the Rule 504 
exemption still being used by these issuers? If so, for what purposes 
is Rule 504 used? If these foreign private issuers still use the 
exemption, should the Commission treat their Rule 504 issuances 
differently, i.e., not as ``restricted securities'' if they are not 
microcap companies, and file periodic public reports in their home or 
other countries?
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    \30\ 17 CFR 230.701.
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VI. General Request for Comment

    Any interested persons wishing to submit written comment on any of 
the issues set forth in this release are invited to do so by submitting 
them in triplicate to Jonathan G. Katz, Secretary, U.S. Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington D.C. 20549. 
Comments also may be submitted electronically at the following e-mail 
address: <a href="/cdn-cgi/l/email-protection#3a484f565f17595557575f544e497a495f59145d554c"><span class="__cf_email__" data-cfemail="483a3d242d652b2725252d263c3b083b2d2b662f273e">[email protected]</span></a>. All comment letters should refer to 
File Number S7-14-98; this file number should be included on the 
subject line if e-mail is used. Comments received will be available for 
public inspection and copying in the Commission's public reference room 
at 450 Fifth Street, N.W., Washington, D.C. 20549. Electronically 
submitted comment letters will be posted on the Commission's Internet 
Web site (http://www.sec.gov). Comments on this proposal will be 
considered by us in complying with our responsibilities under Section 
19(a) of the Securities Act.\31\ We further request comment on any 
competitive burdens that may result from adoption of the proposals. 
Comments are solicited from the point of view of, among others, 
issuers, underwriters, broker/dealers and the investing public.
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    \31\ 15 U.S.C. 77s(a).
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VII. Summary of Initial Regulatory Flexibility Analysis

    We have prepared an Initial Regulatory Flexibility Analysis 
(``IRFA'') in accordance with the Regulatory Flexibility Act \32\ 
regarding the proposed amendments.
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    \32\ 5 U.S.C. 603.
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    The analysis notes that the amendments to Rule 504 are a result of 
our view--and that of representatives of other regulators--that the 
current configuration of the exemption may be leading to abuse. The 
purpose of the proposals is to reduce the potential for abuse and yet 
maintain the utility of the exemption for small businesses. We believe 
that the proposed amendments will enhance the protection of the 
investing public.
    In calendar year 1997, 1,505 Forms D were filed by 1,397 companies 
with the Commission claiming the Rule 504 exemption. Rule 504 only 
affects non-reporting companies. The Commission has sought to minimize 
the reporting burden on small businesses. However, we do not collect 
data to determine how many of the non-reporting companies filing Form D 
are small businesses. Therefore, we are unable to determine exactly how 
many small businesses will be affected by the proposed amendments.
    While it is not possible to know with certainty, it is believed 
that most Rule 504 offerings were done by small businesses. The rule 
changes would restrict the resale of all securities issued pursuant to 
Rule 504. Officials at the NASD estimate that between 300 and 500 
applications for quotation on the OTC Bulletin Board annually have been 
based on the Rule 504 exemption. We presume, therefore, that the 
proposal would affect at least some of the small businesses currently 
using Rule 504. The proposal, if adopted, could cause these issuers to 
offer higher discounts in the sales of their securities, which may 
increase their overall cost for capital. The Commission has 
insufficient data to reliably quantify the impact on small entities 
offering such a discount, and requests comment, supported by data and 
analysis regarding the nature and size of any discount.
    As discussed more fully in the IRFA, several possible significant 
alternatives to the proposals were considered. These included: 
establishing different compliance or reporting requirements for small 
entities, clarifying, consolidating or simplifying the compliance and 
reporting requirements for small entities, using performance rather 
than design standards, exempting small entities from all or part of the 
proposed requirements, or requiring them to provide more disclosure, 
such as the same disclosure required for the other Regulation D 
exemptions. The IRFA also indicates that there are no current federal 
rules that duplicate, overlap, or conflict with the proposed 
amendments.
    We encourage written comments on any aspect of the IRFA. In 
particular, we seek comment on: (i) the number of small entities that 
would be affected by the proposed amendments; and (ii) whether the 
proposed amendments would affect the reporting, recordkeeping and other 
compliance requirements for small entities and, if so, how. If you 
believe the proposals will significantly impact a substantial number of 
small entities, please describe the nature of the impact and estimate 
the extent of the impact with specific data.
    For purposes of making determinations required by the Small 
Business Regulatory Enforcement Fairness Act of 1996 (``SBREFA''),\33\ 
we also are requesting data regarding the potential impact of the 
proposed amendments on the economy on an annual basis. Your comments 
will be considered in the preparation of the Final Regulatory 
Flexibility Analysis if the proposed amendments are adopted. A copy of 
the Initial Regulatory Flexibility Act Analysis may be obtained from 
Twanna M. Young, Office of Small Business, Division of Corporation 
Finance, Securities and Exchange Commission, 450 Fifth Street, N.W., 
Washington, D.C. 20549.
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    \33\ Pub. L. 104-121, 110 Stat. 857 (1996) (codified in 
scattered sections of 5 U.S.C., 15 U.S.C., and as a note to 5 U.S.C. 
601).
---------------------------------------------------------------------------

VIII. Cost-Benefit Analysis

    The current version of Rule 504 was adopted in 1992. At that time 
it was believed to contain adequate compliance standards, including: 
the limits on the amount of money permitted to be raised and the types 
of issuers eligible to use the exemption; the filing of the Form D 
notification with the Commission to aid in its monitoring of the 
exemption; the federal antifraud provisions; and, perhaps most 
importantly, state regulation of these transactions. Since that time, 
however, securities issued pursuant to Rule 504 have been used in 
fraudulent secondary trading.

[[Page 29173]]

    The proposed amendments would address these problems by restricting 
the resale of securities; generally this change would require investors 
to hold them for at least one year following purchase. The Commission 
believes these proposed amendments, if adopted, would benefit issuers 
and investors by curbing some of the abuses in the secondary market, 
safeguarding investors, and preserving the utility of the exemption for 
legitimate transactions.
    In calendar year 1997, 1,505 Forms D were filed by 1,397 companies 
with the Commission claiming a Rule 504 exemption. Officials at the 
NASD estimate that between 300 and 500 applications for quotation on 
the OTC Bulletin Board annually have been based on the Rule 504 
exemption. The Commission cannot estimate the costs of the proposed 
amendments with certainty. Some issuers may be required to offer 
discounts or other incentives to sell their securities in order to 
compensate for the restriction on resale. However, because the 
exemption is designed to raise ``seed'' capital, most of the issuers 
and the type of transaction the rule is designed to reach are in the 
early stages of their development. These issuers are interested in 
attracting patient investors who are committed to remaining with the 
business for some period of time. As such, it seems reasonable that 
these investors and the companies would expect the securities to be 
held for some period of time; certainly for at least one year. Our 
experience shows that many of the active trading markets that develop 
shortly after securities are issued under Rule 504 are artificial. 
While liquidity is an important feature with any securities investment, 
whether it is sufficiently significant in connection with a ``seed'' 
capital offering to require a substantial discount in the offering 
price is debatable. Nonetheless the Commission is seeking specific 
comments on this issue and empirical data. While the amendments will 
probably impact mostly small entities, the changes are necessary to 
curb fraud in the market for the securities of small issuers. The 
Commission does not have sufficient data to reliably estimate this cost 
and requests data and analysis from commenters.
    As an aid in the evaluation of the costs and benefits of these 
proposals, we request the views and other supporting information of the 
public. It appears to us that the proposed amendments, if adopted, 
would continue to provide the significant cost savings originally 
envisioned for small issuers making offerings under Rule 504 without 
compromising investor protection.
    We request your comment on whether the proposed amendments would be 
a ``major rule'' for purposes of the SBREFA. We request comments on 
whether the proposed amendments are likely to have an annual effect on 
the economy of $100 million or more. Your comments should provide 
empirical data to support your views.
    Section 2(b) of the Securities Act requires the Commission, when 
engaged in rulemaking that requires a public interest finding, to 
consider, in addition to the protection of investors, whether the 
action will promote efficiency, competition and capital 
formation.<SUP>34</SUP> The Commission's preliminary view is that the 
proposed amendments would not have any effect on competition. Moreover, 
the proposed amendments are designed to curb fraud in the market for 
the securities of small issuers, and therefore are likely overall to 
improve efficiency and capital formation for legitimate small 
businesses. The Commission is aware, however, that restricting the 
resale of securities may have some impact on the cost of capital 
formation. The Commission requests data and analysis on what effect the 
proposed changes may have on efficiency, competition and capital 
formation.
---------------------------------------------------------------------------

    \34\ 15 U.S.C. 77b(b).
---------------------------------------------------------------------------

IX. Paperwork Reduction Act

    Our staff has submitted the proposals for review to the Office of 
Management and Budget (``OMB'') in accordance with the Paperwork 
Reduction Act of 1995 (``the Act''). <SUP>35</SUP> The title to the 
affected information collection is: ``Form D.'' The specific 
information that must be included in Form D is explained in the form 
itself, and relates to the issuer, its principals and the amount of 
money proposed to be raised along with proposed applications of the 
proceeds. The information is needed for monitoring use of the exemption 
as well as evaluating its usefulness to issuers.
---------------------------------------------------------------------------

    \35\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

    The collection of information in Form D will continue to be 
required in order for companies to use the rule for sales of their 
securities. The likely respondents to the rule are those companies that 
have previously used the rule and other small entities. While we cannot 
estimate the number of respondents that may use revised Rule 504, there 
were 1,505 Form D filings by 1,397 companies under Rule 504 during 
calendar year 1997. We expect that approximately 1500 companies each 
year will be relying on the exemption. If the revisions to Rule 504 are 
adopted, the estimated burden for responding to the collection of 
information in Form D would not increase for most companies because the 
information required has not been changed. The number of eligible 
transactions, however, may decrease. We estimate that the average 
burden hours per filing will be 16. Therefore, we estimate an aggregate 
of 24,000 burden hours per year. The Commission does not know how many 
issuers may be affected by this proposal, whether they will decide to 
rely on another exemption, or how much, if any, the information 
collection burden would be.
    The information collection requirements imposed by Form D are 
mandatory to the extent that a company elects to use the Rule 504 
exemption. The information is disclosed to the public. An agency may 
not conduct or sponsor, and a person is not required to respond to, a 
collection of information unless it displays a currently valid control 
number.
    In accordance with the Act,<SUP>36</SUP> we solicit comment on: (1) 
whether the collection of information is necessary; (2) the accuracy of 
our estimate of the burden of the collection of information; (3) the 
quality, utility and clarity of the information to be collected; and 
(4) whether the burden of collection of information on those who are to 
respond, including through the use of automated collection techniques 
or other forms of information technology, may be minimized.
---------------------------------------------------------------------------

    \36\ 44 U.S.C. 3506(c)(2)(B).
---------------------------------------------------------------------------

    Persons desiring to submit comments on the collection of 
information requirement should direct them to the Office of Management 
and Budget, Attention: Desk Officer for the Securities and Exchange 
Commission, Office of Information and Regulatory Affairs, Washington, 
D.C. 20503, and should also send a copy of their comments to Jonathan 
G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth 
Street, N.W., Washington, D.C. 20549, with reference to File No. S7-14 
-98. The Office of Management and Budget is required to make a decision 
concerning the collection of information between 30 and 60 days after 
publication, so a comment to OMB is best assured of having its full 
effect if OMB receives it within 30 days of publication.

X. Statutory Basis for the Proposals

    The amendments are proposed pursuant to Sections 2, 3(b), 6, 7, 8, 
10, 19(a), 19(c) and 28 of the Securities Act.

[[Page 29174]]

List of Subjects in 17 CFR Part 230

    Reporting and recordkeeping requirements, Securities.

Text of Rule and Form Proposals

    For the reasons set out in the preamble, title 17, chapter II of 
the Code of Federal Regulations is proposed to be amended as follows:

PART 230--GENERAL RULES AND REGULATIONS, SECURITIES ACT OF 1933

    1. The citation for Part 230 continues to read in part as follows:

    Authority: 15 U.S.C. 77b, 77f, 77g, 77h, 77j, 77r, 77s, 77sss, 
78c, 78d, 78l, 78m, 78n, 78o, 78w, 78ll(d), 79t, 80a-8, 80a-24, 80a-
29, 80a-30, and 80a-37, unless otherwise noted.
* * * * *


Sec. 230.502  [Amended]

    2. By amending the introductory text of paragraph (d) of 
Sec. 230.502 by revising the words ``Except as provided in 
Sec. 230.504(b)(1), securities'' to read ``Securities''.
    3. By revising Sec. 230.504(b)(1) to read as follows:


Sec. 230.504  Exemption for limited offerings and sales of securities 
not exceeding $1,000,000.

* * * * *
    (b) Conditions to be met.--(1) General conditions. To qualify for 
exemption under this Sec. 230.504, offers and sales must satisfy the 
terms and conditions of Secs. 230.501 and 230.502(a) and (d).
* * * * *
    Dated: May 21, 1998.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-14024 Filed 5-27-98; 8:45 am]
BILLING CODE 8010-01-P


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