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Rule 504, Securities and Exchange Commission
Chapman, Spira & Carson - Disscusion

From: Robert A. Spira
Date: 2/22/99
Time: 6:01:26 PM
Remote User:


The Securities and Exchange Commission Rule 504 was adopted to aid small businesses raise capital, Under the regulation, a broker can sell stock to an unlimited number of people without a formal prospectus and without regard to their experiance, sophistication or financial acumen. The only drawback to this regulation is the fact that only $1 million may be raised utilizing this process during a 12 month period. Reporting companies are not allowed to file under this regulation. Regulation D offerings are exempt for registration requirements, but must past mustard under the individual state's "blue sky" regulations. The SEC indicates that "Unfortunately, since adoption of certain revisions to Rule 504 in 1992, there have been some recednt disturbing developments in the secondary markets for some securities initially issued under Rule 504 and to a lesser degree, in the initial Rule 504 issuances themselves. These offerings generally involve the securities of "microcap" companies. Recent market innovations and technolgical changes, mot notably, the Internet, have created the possibility of nation-wide Rule 504 offerinings for securities of non-reporting companies that were once thought to be sold locally. In some cases, Rule 504 has been used in fraudulent schemes to make prearranged "sales" of securities under the rule to nominees in states that do not have registration or prospectus delivery requirements. As a part of this arrangement, these securities areed then placedd with broker-dealers who use cold-calling techniqaues to sell the securities at ever-increasing prices to unkowing investors. When their inventory of shares is exhauksted, these firms permit the artificial market demand created to collapse, and investors, lose much, if not all, of their investment. This scheme is sometimes colloquially referred to as "pump and dump." The Commisssion will consider amendments to Rule 504 to deter these abuses yet preserve the ability of legitimate small businesses to raise capital. These amendments would establish the general principle that securiters issued in a Rule 504 transaction, just like the other Regulation D exemptions, would be restricted, and would prohibit general solcicitation and general advertising, unlesss the specified conditions for a public Rule 504 offering are met. These conditions would be:the transactions are registered under a state law requiring public filing and delivery of a substantive disclosure document to investors before sale. For sales to occur in a state without this sort of provision, the transactions must be registered in another state with such a provision and the disclosure document filed in the 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 advertising, so long as sales are made only to accredited investors as that term is defined in Regulation D. 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. 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 (insert date 60 days after publication in the FEDERAL REGISTER).

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: 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 Street, N.W., Washington, D.C. 20549. We will post comment letters submitted electronically on our Internet Web site (

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. [ 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." ] In response to that Act, the Commission adopted Regulation D [ 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.] under the Securities Act of 1933 ("Securities Act") [ 15 U.S.C. 77a et seq .] in 1982. [ See Release No. 33-6389 (March 8, 1982) (47 FR 11251).] 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 [ 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.] 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. [ 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)).] Securities sold under the exemption may be resold freely by non-affiliates of the issuer. [ 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.]

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. [ 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).] 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. [ 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.] These offerings continue, however, to be subject to federal antifraud and other civil liability provisions.

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. [ 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. ] 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, [ 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.] we also believe that a regulatory response may be necessary. [ 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.] 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. [ 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.] 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.

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.


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 [ 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).] 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. [ 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.] 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.

In July 1992, the Commission adopted revisions to its rules and forms to further facilitate capital raising by small businesses. [ 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). ] 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" [ Section 2(a)(11) of the Securities Act (15 U.S.C. 77b(a)(11)).] of the offering. [ 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.]

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. [ 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.] 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.

There have been a significant number of recent Commission examinations of broker/dealers and enforcement investigations with allegations of fraud involving microcap companies. [ 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).] 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.

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. [ This technique is sometimes colloquially referred to as "pump and dump."] 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.


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 [ 17 CFR 230.251 et seq .] ), if available.

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. [ 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. ]


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," [ 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.] 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?

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. [ 17 CFR 230.502(b).] 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 [ 5 U.S.C. 552.] ? Should a confidential treatment process be developed to protect some of the information contained in these documents?


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? [ 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.]

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? [ See note 16 above.] 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? [ 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). ]

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? 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

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