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

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: rule-

[email protected]. 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

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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.1 In response to that Act,

the Commission adopted Regulation D 2 under the Securities

Act of 1933 (``Securities Act'') 3 in 1982.4 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 5 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.6 Securities sold under the exemption may be resold

freely by non-affiliates of the issuer.7

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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.8 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.9 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.10 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,11

we also believe that a regulatory response may be

necessary.12 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.13 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 14 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.15

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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.16 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'' 17 of the offering.18

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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.19 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.20 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.21

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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 A22), 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.23

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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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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?

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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: [email protected]. 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).

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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.34 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.

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

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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''). 35 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.

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

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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,36 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.

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

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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