Problematic Practices Under Regulation S

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 231

[Release No. 33-7190; International Series No. 821; File No. S7-20-95]

Problematic Practices Under Regulation S

AGENCY: Securities and Exchange Commission.

ACTION: Interpretive Release; Request for Comments.

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SUMMARY: The Commission is publishing its views concerning problematic

practices under Regulation S and is requesting comment as to whether

Regulation S should be amended to limit its vulnerability to abuse. The

Commission will study the comments received in response to this release

and will determine whether rulemaking or other action is necessary or

appropriate.

DATES: This interpretation is effective July 10, 1995. Comments should

be received on or before September 8, 1995.

ADDRESSES: Comment letters should refer to File number S7-20-95 and

should be submitted in triplicate to Jonathan G. Katz, Secretary, U.S.

Securities and Exchange Commission, 450 Fifth Street, N.W., Washington,

D.C. 20549. The Commission will make all comments available for public

inspection and copying in its Public Reference Room at the same

address.

FOR FURTHER INFORMATION CONTACT: Paul Dudek or Annemarie Tierney, (202)

942-2990, Office of International Corporate Finance, Division of

Corporation Finance, U.S. Securities and Exchange Commission,

Washington, D.C. 20549.

SUPPLEMENTARY INFORMATION: The Commission is stating its views with

respect to certain problematic practices in connection with offers and

sales under Regulation S,1 the safe harbor under the Securities

Act of 1933 (the ``Securities Act'') 2 for offshore offerings or

resales, and is requesting comment as to whether specific amendments to

Regulation S are necessary to curtail Regulation S abuses.

\1\ 17 CFR 230.901-904.

\2\ 15 U.S.C. 77a et seq.

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In addition, in a companion release,3 the Commission is

publishing for comment rule revisions that would eliminate certain

impediments to registered offerings of securities under the Securities

Act by streamlining requirements with respect to financial statements

of significant acquisitions. Also in the companion release, rule

revisions are proposed that would require registrants to report on a

quarterly basis recent sales of equity securities that have not been

registered under the Securities Act.

\3\ Securities Act Release No. 7189.

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I. Introduction

The Commission adopted Regulation S in April 1990 in order to

clarify the extraterritorial application of the registration

requirements of the Securities Act.4 Since adoption, a number of

problematic practices have developed involving unregistered sales of

equity securities of domestic reporting companies purportedly in

reliance upon Regulation S. In this release, the Commission states its

views concerning these problematic practices and is requesting comment

as to whether Regulation S also should be amended to impose additional

restrictions on its use to impede attempts to use the Regulation to

evade the registration requirements of the Securities Act.

\4\ Securities Act Release No. 6863 (April 24, 1990) [55 FR

18306] (the ``Adopting Release'').

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Commenters have suggested that companies may be compelled to sell

securities offshore, rather than in registered transactions, because of

the registration disclosure requirements relating to significant

acquisitions. In a companion release, the Commission is proposing to

streamline these requirements to reduce regulatory impediments to the

use of registered offerings. Also, in response to commenters'

suggestions that investors need information about private or offshore

placements of equity securities that is not currently required to be

disclosed, the Commission is proposing to require quarterly reporting

of unregistered equity offerings. Commenters have suggested this public

reporting may also have the ancillary benefit of deterring abuses of

Regulation S. The Commission in this release is soliciting comment as

to other regulatory burdens that may cause issuers to resort to

offshore offerings rather than registered public offerings.

II. Interpretive Guidance on Regulation S Practices

Regulation S contains a general statement providing that Section 5

of the Securities Act 5 shall be deemed not to apply to offers or

sales of securities that occur outside the United States 6 and two

non-exclusive safe harbors.7 However, neither of the safe harbors

nor the general statement is available for a transaction or series of

transactions that, although in technical compliance with the

regulation, is part of a plan or scheme to evade the registration

requirements of the Securities Act.8

\5\ 15 U.S.C. 77(e).

\6\ See Rule 901. Whether a transaction occurs outside the

United States within the meaning of Rule 901 is a question of the

facts and circumstances of the transaction. See the Adopting Release

at footnote 18 and accompanying text.

\7\ See Rules 903 and 904.

\8\ See Preliminary Note 2 to Regulation S.

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Preliminary Note 2 to Regulation S states that ``* * * Regulation S

is not available with respect to any transaction or series of

transactions that, although in technical compliance with these rules,

is part of a plan or scheme to evade the registration provisions of the

Act. In such cases, registration under the Act is required.'' This

release pertains only to violations of Section 5 in connection with

Regulation S offerings and does not address issues dealing with the

antifraud provisions of the federal securities laws.

The safe harbors provide specific guidance to issuers and other

market participants as to conditions under which a transaction will be

deemed to occur outside the United States. One safe harbor applies to

offers and sales by issuers, underwriters and other persons involved in

the distribution process pursuant to contract (defined as

``distributors'') and any person acting on behalf of the foregoing (the

``issuer safe harbor'').9 The other safe harbor applies to resales

by persons other than the issuer, distributors, their respective

affiliates (except certain officers and directors) and persons acting

on behalf of the foregoing (the ``resale safe harbor'').10 An

offer and sale of securities that satisfies all conditions of the

applicable safe harbor is deemed to be outside the United States and

thus is not subject to the registration requirements of Section 5,

provided that it is not part of a plan or scheme to evade

registration.11

\9\ See Rule 903. The issuer safe harbor distinguishes three

categories of securities offerings, based upon factors such as the

nationality and reporting status of the issuer and the degree of

U.S. market interest in the issuer's securities. Under the issuer

safe harbor, varying procedural safeguards are imposed with the

intent of having the securities offered come to rest offshore.

\10\ See Rule 904.

\11\ Section 5 of the Securities Act prohibits any person,

directly or indirectly, from using instrumentalities of interstate

commerce or the mails to offer or sell a security unless a

registration statement has been filed or is in effect as to such

security. Exemptions from the registration provisions are set forth

in Sections 3 and 4 of the statute, and the related rules

promulgated under the Securities Act. A person who offers or sells a

security in reliance upon an exemption from the registration

requirements of Section 5 has the burden of establishing the

availability of the exemption. Securities & Exchange Commission v.

Murphy, 626 F.2d 633, 645 (9th Cir. 1980). Such exemptions are

construed narrowly. Id. at 641.

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Since the adoption of Regulation S, it has come to the Commission's

attention that some market participants are conducting placements of

securities purportedly offshore under Regulation S under circumstances

that indicate that such securities are in essence being placed offshore

temporarily to evade registration requirements with the result that the

incidence of ownership of the securities never leaves the U.S. market,

or that a substantial portion of the economic risk relating thereto is

left in or is returned to the U.S. market during the restricted period,

or that the transaction is such that there was no reasonable

expectation that the securities could be viewed as actually coming to

rest abroad. These transactions are the types of activities that run

afoul of Preliminary Note 2, would not be covered by the safe harbors

and would be found not to be an offer and sale outside the United

States for purposes of the general statement under Rule 901.12

\12\ In addition, a purported Regulation S offering that

involves a distribution in the United States may raise issues under

Rule 10b-6 under the Securities Exchange Act of 1934. See, e.g.,

R.A. Holman & Co., Inc. v. Securities & Exchange Commission, 366

F.2d. 446, at 449, (2d Cir. 1966) (a distribution of securities is

not deemed to be completed until the securities come to rest in the

hands of the investing public).

The practices described below generally have involved equity

securities of U.S. companies whose securities are traded principally,

and typically solely, in the United States.

There have been a variety of schemes involving parking securities

with offshore affiliates of the issuer or a distributor. In these

transactions, Regulation S is claimed as the basis to sell securities

to offshore shell entities formed by the issuer or a distributor (or,

in some cases, persons closely associated with the issuer or

distributor) to purchase the securities. The entities hold the

securities for the restricted period; at the end of that period,

proceeds from the U.S. sale make their way, directly or indirectly, to

the issuer or distributor. These transactions do not qualify for either

the Regulation S safe harbor or the Rule 901 general statement since

they are nothing more than sham offshore transactions structured to

evade the Securities Act registration requirements.

Troubling issues also have arisen under the resale safe harbor

provisions of Rule 904. Rule 904 cannot be used for the purpose of

``washing off'' resale restrictions, such as the holding period

requirement for restricted securities in Rule 144.13 Likewise, the

restricted status of securities is not affected by a prearranged

transaction by or on behalf of the seller conducted offshore. If a

person with restricted securities sold the securities in an offshore

transaction and replaced them with a repurchase of fungible

unrestricted securities, the replacement securities would be subject to

the same restrictions as those replaced.

\13\ See Rule 144(d).

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As noted, the Commission has become aware of a number of instances

where the total mix of factors raises the concerns described above.

These factors, any one of which may serve to indicate that the economic

or investment risk never shifted to the offshore purchaser, and that

the securities--as a matter of substance as opposed to form--never left

the United States or remained offshore for less than the restricted

period, have included the use of: (i) non-recourse promissory notes

(notes where the purchaser never is at risk in connection with the

purchase of the securities) for all or almost all of the purchase

price, where the expectation of repayment stems from the resale of the

securities into the U.S. market, (ii) recourse notes where the entity

providing the notes is unknown to the seller of the securities or the

entity has no, or minimal, assets where, again, the expectation of

repayment stems from the resale of the securities into the U.S. market,

(iii) fees paid to the purchaser of the securities to hold the

securities for the restricted period, whether paid directly or as more

frequently seems to be done through significant 14 discounts to

the U.S. market price for the issuer's stock, where the fees or

discounts are such to indicate that the transaction was intended to

create a parking scheme or other scheme where the securities were

merely being held offshore to evade the registration requirements, and

(iv) short selling and other hedging transactions such as option

writing, equity swaps or other types of derivative transactions,15

where purchasers transfer the benefits and burdens of ownership back to

the United States market during the restricted period.16

\14\ Of course, some discounts may well be warranted in order to

compensate for the length of the restricted period, historic

volatility of the stock, financial condition of the issuer, the

dilution represented by the newly issued shares, current market

condition, availability of current information as to the issuer,

information the issuer may have had that was disclosed to the

purchaser but not otherwise disclosed to the market, or other

factors. Nevertheless, some discounts have been so unrelated to the

economics of the transaction that the only justification that can be

ascertained is that they are part of a parking or holding scheme

where the offshore purchaser is simply being used as a conduit for

what is in reality an onshore financing.

\15\ See Securities Act Release No. 7187, Part II.A, which

addresses equity swaps and other like investment strategies in

different contexts.

Securities would not be deemed to have come to rest abroad

during the restricted period if the securities were pledged as

collateral, either in a margin account or otherwise, where the

expectation was that the collateralization would shift the benefits

and burdens of ownership to the lender as opposed to the purchaser

and the lender was not offshore.

\16\ Since the market for the securities is in the United

States, the short-selling or other hedging transaction occurs in the

United States markets. If the short-selling or other hedging

transaction occurred solely by or among parties offshore, and the

purchaser engaged in the transaction could reasonably expect that

the economic risk of ownership would remain abroad, then the

transaction could satisfy the requirements of the rule if the other

provisions of Regulation S were satisfied.

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In these cases it appears the transaction is nothing more than a

delayed sale by the seller in the United States, with the purported

offshore purchaser serving as a statutory underwriter.17

\17\ Public resales in the United States by persons that would

be deemed underwriters under Section 2(11) of the Securities Act [15

U.S.C. 77b(11)] would not be permissible without registration or an

exemption from registration. Footnote 110 of the Adopting Release,

which addresses the restricted periods, should not be read to

provide otherwise.

Section 4(1) of the Securities Act [15 U.S.C. 77d(1)] exempts

``transactions by any person other than an issuer, underwriter, or

dealer.'' Section 2(11) defines the term ``underwriter'' as:

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. . . . As used in this

paragraph the term ``issuer'' shall include, in addition to an

issuer, any person directly or indirectly controlling or controlled

by the issuer, or any person under direct or indirect common control

with the issuer.

Accordingly, any distributions by a statutory ``underwriter''

must be registered pursuant to Section 5. United States v. Wolfson,

405 F.2d 779, 782 (2d Cir. 1968), cert. denied, 394 U.S. 946 (1969).

III. Request for Comments

In addition to taking enforcement action against those who seek to

evade the registration requirements of the Securities Act under the

color of compliance with Regulation S,18 the Commission is

considering whether it is necessary to amend the regulation to deter

these abuses and requests comment as to the need for revision of

Regulation S. A number of proposed revisions have been suggested by

commentators.19 These suggestions are

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being considered by the Commission and comment is requested on each of

the proposals that follow. Commentators' proposals have generally

focused on common stock placements by domestic issuers. Is there a

comparable need for such restrictions in the case of foreign issuers'

equity for which the United States is the sole or principal market, or

for any other class of securities?

\18\ See, for example, United States v. Sung and Feher,

Litigation Release No. 14500 (May 15, 1995); Securities and Exchange

Commission v. Softpoint, Inc., et al., Litigation Release No. 14480

(April 27, 1995).

\19\ See Ajhar, ``Foreign Stock Sales: Don't Get Blindsided,''

Worth p. 37 (March 1994); The Corporate Counsel, March-April 1995;

E. Greene, ``Recent Problems Under Regulation S,'' Insights (August

1994); ``Rule Permitting Offshore Stock Sales Yields Deals that

Spark SEC Concerns'', Wall Street Journal, at C1, April 26, 1994.

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1. Extend the Restricted Period. Currently, the restricted period

under the category 2 safe harbor 20 for offerings of securities of

domestic companies that are reporting under the Securities Exchange Act

of 1934 (the ``Exchange Act'') 21 is 40 days. Some have suggested

extending the restricted period, for example, to one year in the case

of equity securities of domestic issuers. One commentator has suggested

that such offerings should be subject to the more restrictive

conditions of the category 3 safe harbor,22 which are currently

generally applicable to offshore offerings by non-reporting domestic

issuers. This would not only extend the restricted period to one year

but also require legending of share certificates and an express

agreement by the purchaser to resell the securities only in accordance

with an available exemption from registration.

\20\ Rule 903(c)(2).

\21\ 15 U.S.C. 78a et seq.

\22\ Rule 903(c)(3).

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2. Exclude certain discounted offers from the safe harbor. Another

possible revision would be to limit use of the category 2 safe harbor

by domestic issuers offering common stock to those offerings sold at

the market price or with a specified minimal discount. Those selling at

a disqualifying discount could proceed under Rule 901 if the facts and

circumstances established that the placement was truly an offshore

offer and sale and not part of a plan or scheme to evade the

registration requirements of the Securities Act. Alternatively, rather

than exclude some or all discounted offerings from the issuer safe

harbors, should instead a longer restricted period or all of the

category 3 procedures apply to discounted offers?

3. Restrict risk shifting transactions during the restricted

period. Should the safe harbor require selling restrictions that limit

purchasers' ability during the restricted period to sell short or

otherwise take a short position with respect to, or otherwise hedge the

risk of holding common equity securities?

4. Prohibit payment with certain types of non-recourse or other

types of promissory notes where the expectation of repayment derives

solely from the resale of securities. Should the category 2 or 3 safe

harbor be amended to prohibit (or limit through tolling of the

restricted period) payment for common equity securities with certain

types of non-recourse or other types of promissory notes where the

expectation of repayment derives solely (or primarily) from the

proceeds of resale of the securities?

IV. The Role of Regulation S in Companies' Capital Raising Plans

The Commission, when it adopted Regulation S, understood and

intended that legitimate offshore transactions whereby the issuer

intended that its securities would be sold and placed offshore would be

covered by Regulation S. Regulation S clarified and simplified

procedures for offshore placement of securities and was intended to

provide U.S. issuers with an efficient capital raising alternative. The

Commission understands, in part due to its participation in the

Government-Business Forum on Small Business Capital Formation, that

there are issuers, particularly those ineligible to use shelf

registration, that view offshore offerings as an important financing

alternative. The Commission is soliciting comments as to the types of

companies that are using Regulation S, how are they using it, and what

mechanisms can be used to prevent abuse without unduly deterring

legitimate offshore capital raising activities.

Reportedly, many small business issuers consider Regulation S

offerings an important financing tool. Is this due to the increased

pool of potential investors, or to the process involved in

accomplishing a Regulation S offering versus a registered offering, or

both? The Commission also recognizes that issuers may be compelled to

sell securities offshore, rather than in registered transactions,

because of registration disclosure requirements relating to significant

acquisitions. As noted above, in a companion release, the Commission is

addressing this concern through rule proposals to streamline these

disclosure requirements. The Commission is seeking comments as to what

other impediments in the current system may lead to problematic

Regulation S offerings, and what commenters suggest should be done to

alleviate these problems so that resorting to problematic Regulation S

practices can be eliminated.23

\23\ The Commission has established the Advisory Committee on

the Capital Formation and Regulatory Processes (the ``Advisory

Committee''), chaired by Commissioner Steven M.H. Wallman. The

Advisory Committee is considering fundamental issues relating to the

regulatory framework governing the capital formation process,

including whether the current system of registering securities

offerings should be replaced with a company registration system. The

recommendations of the Advisory Committee may result in rule

proposals or legislative recommendations that, if endorsed by the

Commission, ultimately may address the matters discussed in this

release. Under some of the company registration models being

considered by the Advisory Committee, the need to draw legal

distinctions between securities issued by registered companies in

public offerings conducted domestically and offshore would be

significantly reduced. All securities issued by companies registered

with the Commission would be freely tradable in this country,

regardless of the public or private, or domestic or offshore, nature

of that offering.

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Further, the Commission requests that commenters address the

benefits and costs and other burdens to investors, issuers, and other

market participants that would result from any of the suggested changes

to Regulation S noted in Section III above.

V. Cost-Benefit Analysis

The Commission requests views and data relating to the costs and

benefits associated with the proposals relating to additional

restrictions for offerings under Regulation S. It is expected that such

restrictions would not directly impose additional burdens on companies,

although there may be indirect costs incurred by companies.

VI. Request for Comments

Any interested person wishing to submit written comments on any

aspect of the amendments to forms and rules that are subject to this

release are requested to do so. Comments should be submitted in

triplicate to Jonathan G. Katz, Secretary, U.S. Securities and Exchange

Commission, 450 5th Street, NW., Washington, DC 20549 and should refer

to file number S7-20-95.

List of Subjects in 17 CFR Part 231

Securities.

Amendment of the Code of Federal Regulations

For the reasons set out in the preamble, Title 17 Chapter II of the

Code of Federal Regulations is amended as set forth below:

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PART 231--INTERPRETATIVE RELEASES RELATING TO THE SECURITIES ACT OF

1933 AND GENERAL RULES AND REGULATIONS THEREUNDER

Part 231 is amended by adding Release No. 33-7190 and the release

date of June 27, 1995 to the list of interpretive releases.

Dated: June 27, 1995.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 95-16393 Filed 7-7-95; 8:45 am]

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