Source: TKTK
Brief Overview of Other Methods
Source: TKTK
offerings are taking place are not too thrilled with Regulation A either, and that may be one of the reasons for its limited popularity—the inability to
“clear” blue sky review to let an offering be completed.
I have heard from SEC insiders that a potential overhaul of Regulation A is in the works, and an increase in the amount allowed to be raised may be coming. It is not clear at this point whether that will entice investment banks and others to come back to Regulation A (if they were ever there in the fi rst place).
Intrastate Exemption
The SEC and federal agencies are only able, generally speaking, to regulate interstate commerce. This means that a transaction occurring wholly in only one state may be outside their jurisdiction. In fact, the securities laws contain an express exemption from registration for an offering that takes place wholly within one state.
Some have gone to states where regulation of securities is light (these are becoming fewer and fewer) and completed offerings solely within that state to avoid the necessity of SEC registration. The company also must be physically located and incorporated in that state. The key is being in a state whose regulation would somehow allow for an easier time than SEC registration.
Most states provide that an offering which would otherwise be public for SEC purposes requires the preparation and approval by state regulators of a full disclosure document. It is also not clear whether shares are restrict- ed after being offered in an intrastate transaction. If they are restricted, although the offering itself is exempt, the shares still must be held for the requisite Rule 144 period before trading can commence.
These offerings are hard to pull off and have not been widely used to my knowledge.
Rule 504
An SEC exemption from registration under Rule 504 of Regulation D can be a dangerous transaction to get involved with. Here’s how it works: Rule 504 allows an exemption from registration if an offering is below $1 mil- lion in total. Thus, these smaller offerings were somehow deemed to not need stringent regulation. This had the effect of allowing the tiniest compa- nies to raise money and go public without signifi cant transactional cost.
Other Regulation D offerings require signifi cant disclosure to any nonaccredited investor and limit the number of nonaccredited investors participating in a deal to thirty-fi ve. In a Rule 504 transaction, an offer- ing can be completed to any number of accredited and nonaccredited investors, all without any specifi c information delivery requirements.
Source: TKTK
Thus, one thousand nonaccredited investors could each invest $1,000 under Rule 504 and all the company needs to provide is a simple subscription agreement and no other disclosure. SEC Rule 10b-5 pro- hibits misleading someone in connection with a securities offering, but it assumes intentional fraud. Mere failure to provide information, unless shown to be done with the intent to hide something, is not necessarily actionable by an unhappy investor.
The clincher is, unlike other Regulation D offerings, the stock issued in a Rule 504 transaction is immediately tradable if a ticker exists and the stock may be traded, typically on the Pink Sheets. Thus, companies will complete a small offering, obtain a ticker, and proceed to have a trading stock without ever providing full disclosure, becoming a reporting com- pany or, frankly, ever intending to become a reporting company.
The obvious advantages to company management and the deal pro- moters is the ability to begin to cash out of their stock (assuming the availability of Rule 144 for other shares issued in the company outside the Rule 504 offering), all without providing any sort of public fi ling or public information.
During the 1980s and 1990s in particular, Rule 504 caught on as a way to take companies public, especially after the passage of Rule 419 in 1992 restricting the initial public offerings of blank check companies. Unfortu- nately, many players in this fi eld were unsavory types looking to engage in improper, illegal, and fraudulent activity, and many SEC investigations and actions resulted from Rule 504 offerings gone bad.
Rule 504 is still on the books, but as a practical matter its use has been all but eliminated. In many cases, the SEC responds when shady operators gather in one particular part of the fi nancial world. In this case, it was the state regulators overseeing securities matters who one by one essentially said, “Don’t try to do a Rule 504 offering in our state, we will not permit it.” I believe only about eight states still allow 504 offerings. So as a result, only the hardiest promoters can move forward with this type of transac- tion. Unfortunately, as was the case with reverse mergers for a long time, most people associate Rule 504 offerings with players to be avoided, and I continue to count myself among them.
Where could Rule 504 have been practical in the legitimate capital market environment? In a private placement for $1 million for an already public company that is reporting, and where a full disclosure document is prepared and/or there is a desire to bring in more than thirty-fi ve un- accredited investors. Then, tradable shares would immediately result in an already existing trading market, no one would question the informa- tion delivery process, and money could be raised. Unfortunately, again the baby was thrown out with the bath water when the states all but killed
Source: TKTK
this exemption even though there were some valid potential uses. I have represented legitimate players trying to use Rule 504 in this manner, only to be shut down by the states. So, although once popular, this technique is effectively unavailable.
PRACTICE TIP
Avoid Rule 504 offerings unless one is very, very careful.
Regulation S
In 1990, the SEC passed the now infamous Regulation S, or Reg S. After several court cases, the SEC had to admit it had no jurisdiction over events outside the United States. Then it came up with a way to regulate foreign companies and offerings as long as some U.S. connection existed. Regula- tion S originally exempted from registration securities offerings by U.S.
companies if the investment was completely or partially from foreigners or by a foreign company if raising money completely overseas when some directed selling efforts took place in the United States.
The clinchers were, fi rst, that no information delivery or accredited investor status mattered, and second, that the original rule seemed to sug- gest that shares issued in a Regulation S exempt offering could be resold publicly without restriction within forty-one days of being issued. So one could offer to any number of offshore investors, whether or not accred- ited, without any information, all without requiring SEC registration by a U.S. company.
There were some who argued the SEC had no right to regulate this kind of offshore offering in any event, but since the regulation focused on U.S. companies, the SEC won the argument.
Resell after forty-one days? Doesn’t Rule 144 require a one-year wait- ing period? And doesn’t everyone else have to be registered if they want to sell before that? The SEC says they meant the shares could be sold publicly outside the United States in forty-one days. But the rule neglected to make that distinction. So savvy promoters, with extremely well-paid lawyers in tow, went forward doing these deals with solid legal opinions as to the shares’ ability to be resold in the United States in forty-one days.
Very quickly, commentators began to do what they do, highlighting the obvious issues. About half of them said the SEC could not have meant resale in the United States, and the other half said that since there is no precedent, anyone is free to interpret the regulation in any reasonable way.
Unfortunately, the SEC could not simply change or amend the rule quick- ly, since that type of change involves a lengthy rule-making process, not to mention the embarrassment of admitting what appears to have been a simple drafting error that created a cottage industry.
Source: TKTK
I’ll give you the end of the story and then we’ll go back to talk about how Regulation S involved the birth of PIPEs. In 1998, the SEC fi nally got its act together and, rather than admit the mistake, it simply amended the rule to say you can resell publicly after one year—in other words, the same basic time period as in Rule 144. This effectively mooted the ques- tion of whether or not it meant sale in the United States. That was pretty much the end of the use of Regulation S in the manner I am about to describe.
So what happened when Regulation S came along? Offshore hedge funds and investors had a fi eld day. Company after company went public through a Regulation S offering where the offshore investors resold their shares in the United States after just forty-one days following what was basically a private offering permitted under Regulation S. Investors loved that they could invest privately, then have a public market almost imme- diately. Sound familiar? Yes, these deals were the predecessors to modern PIPEs, and indeed many PIPE players got their start doing Regulation S deals in the early and mid-1990s.
What was good and bad? Well, lawyers giving Regulation S opinions were very well paid. Why? Because it was clearly controversial to provide such opinions and it involved a little risk for the attorney. As for me, after talking to SEC experts on Regulation S and hearing them say privately,
“Do not view our silence on this issue as acquiescence,” I decided to not represent clients on Regulation S deals where I was being asked to provide a forty-one-day U.S. resale opinion. This did not mean that anyone who did represent these clients was bad; it was just a choice I made.
Some unscrupulous actors clearly took advantage. They made no dis- closure, got foreign investors in, and then out in forty-one days. The com- pany got its money, the original investor made a tidy profi t, and shares traded after that based on essentially no information. Good guys made disclosure prior to the investment. Some became reporting companies voluntarily. Some took the conservative approach and only allowed resale outside the United States.
But for experienced hedge fund investors, Regulation S created a real opportunity to help growing companies and make a quick profi t. They had no interest in being investors, just arbitrageurs. This same attitude pervaded the PIPE market in the late 1990s and early 2000s. Deals were structured to maximize the incentive for the investor to sell quickly after his shares were registered.
Since 2002, life is much different in the PIPEs world. Transaction structures have changed, the hedge fund investment community has grown more crowded, and PIPE investors truly are more like investors now, betting on the longer term upside potential of a company’s stock.
Source: TKTK
This is the main reason why many PIPE investors have discovered reverse mergers, as a more risky opportunity to invest in a company’s future but with much greater upside potential.
These days, about the only real benefi t Regulation S has is for a foreign company to raise money from foreign investors, but possibly through a U.S. investment bank. The forty-one-day exemption still applies in that circumstance. But for some, it was quite a ride there for a while.