Hello Harold,hopefully we will start to see a turn around,in the meantime here is Sat.nights lesson-Reg S 101<vbg>..DD
enjoy the reading(even though it's old-it's good)
Rogue Missives
Friday, March 07, 1997
Rethinking Regulation S
by Louis Corrigan (RgeSeymour)
Imagine if a public company were allowed to issue shares on the sly,
without telling its shareholders what it was up to. And let's say the firm
issued millions of shares, offering them in a private placement at a 15% to
40% discount to the going market price, compensating one class of
investors for potential risks even as others paid full price on the public
market.
Now imagine what would happen if the folks who bought into the private
placement could turn around and sell their shares on the open market
before the rest of a company's shareholders even knew their stake had
been diluted. The huge new supply of shares would hit the market, the
stock's price would drop, and the average investor would be left virtually
clueless about what had happened until is was way too late to act.
Not a pretty scenario. Yet it was a relatively common one until last
October. That's when the Securities and Exchange Commission (SEC)
enacted a new rule designed to stop certain abuses of Regulation S, a
section of the federal law that permits public companies to sell unregistered
securities to overseas investors.
Now, just four months later, the SEC has issued proposals that present
new obstacles to the unscrupulous investors and often questionable issuers
that have preyed on the investing public by taking advantage of this safe
harbor exemption from the SEC's basic public disclosure requirements.
Individual investors should once again tip their collective hats to SEC
Chairman Arthur Levitt and his reform-minded sidekick Commissioner
Steven Wallman.
Back in October, Levitt said that there were "pirates in this safe harbor."
When the new proposals were issued on February 20th, he followed up on
the theme. "Today, we launch a regulatory armada that should drive most
of the marauders out."
In one respect, the SEC's recent and proposed revisions to Reg S
represent the triumph of rational policy-making over the misleading
one-world rhetoric that has often accompanied efforts to make global
capital markets "free and open."
After it was adopted in 1990, Reg S was hailed by many experts in the
field of international financial law as an important advance that would make
it cheaper and easier for U.S. companies to raise money overseas. That's
because they could now do so without having to comply with "the
burdensome U.S. registration requirements," in the words of two
commentators in the journal Euromoney. Other supporters, writing in the
International Financial Law Review, hailed Reg S as "an enlightened and
far-reaching accommodation by the SEC to the realities of the growing
global market for securities."
What these supporters failed to consider is that the health of the U.S.
financial markets is inextricably tied to the fact that the Securities Acts
establish ground rules for public companies that are among the toughest in
the world. The essential goal of those laws is to permit capital formation
within the context of public disclosure of basic material information. It's
hard to believe that your average reasonable investor would consider new
share offerings immaterial.
Bending disclosure requirements simply to promote the presumed "free"
flow of capital essentially damages the basic support for the whole system.
That's because it's difficult to maintain the integrity of a system built on
information when some private investors are allowed special access to
information that can actually harm those investors who are kept in the dark.
The best way to promote the efficient flow of capital, then, is to establish
rational policies that mandate equal disclosure.
The SEC is not there yet. But the recent efforts to revamp Regulation S
represent important strides to clean up what has become a real mess.
Prior to the October 1996 rule change, an issuing company could place
shares with overseas investors without giving timely public notice that it was
doing so. In many instances, those shares could be flipped back into the
U.S. market after just 40 days, long before a company submitted a new
filing to the SEC. Thus the shares often hit the market before most of the
company's public shareholders even knew they existed.
Making matters worse, these "overseas" investors, who in some cases are
simply U.S. investors operating through offshore shell companies, often
hedge their investments by using options or short sales. That's especially
true when the issuing company is a risky firm traded on the Nasdaq
SmallCap market or on the OTC Bulletin Board. These companies often
turn to Reg S offerings out of sheer desperation for cash to keep going.
Indeed, some private placement firms make their living by proposing Reg S
deals to such companies.
Given the risks, many of these deals can only get done if the shares are
offered at a deep discount to the current market value. Thus offshore
investors have often found themselves with a near sure-thing. With a stock
trading at $10 a share, for example, they may be able to buy into the Reg S
offering at $8 a share or less and short the stock at the same time. After 40
days, and regardless of how the stock fares on the open market, the
investors can use the placement to cover their short position and simply
walk away with an easy 25% profit.
Making matters even sweeter for such investors, some of these deals have
been done with promissory notes. Investors could put virtually no money
down until they actually sold their shares. What this meant, in effect, is that
these "offshore" offering ultimately raised money via the U.S. market as the
capital was actually coming from U.S. investors who bought the shares
once the 40 day holding period was over.
What the October 1996 ruling did was establish clear disclosure
requirements consistent with the spirit of the U.S. security acts more
generally. The rule required companies to report other types of private
placements in their quarterly 10Q filings. The Commission deemed this
sufficient since shares offered under Regulation D, for instance, are
generally restricted for up to two years and must be registered before they
can be sold on the market.
That system, however, wasn't sufficient for Reg S offerings. The new rule
required companies to report Reg S offerings on Form 8-K to be filed with
the SEC within 15 days of the sale of securities. Buyers might still decide to
flip their shares after 40 days, but other investors would at least be
prepared.
Of course, this stopgap measure addressed only one of the relevant
problems. As a result, it may have pushed issuers into employing even
more dilutive Reg S offerings involving convertible debentures. Such
offerings can be structured in perfectly rational ways that leave a fair degree
of risk in the deal for offshore investors. In the worse cases, however, they
can seriously dilute a company's common stock. That's because the
requirement for timely disclosure creates a new degree of risk for offshore
investors, particularly if they expect hedging to be difficult. That's because
other investors will know the dilution is coming, so the stock's value may
drop below even a deeply discounted offer price.
Some convertible preferred stock offerings allow offshore investors to
convert their capital into shares at a significant discount not to the current
market price but to the closing price on the day of the conversion. What
this means is that they are virtually assured a profit when they decide to
convert. It also means they may have a powerful incentive to drive the
stock price down since their set investment dollars can claim a bigger
chunk of the company's ownership the lower the stock price gets.
A recent Reg S convertible preferred floated by the controversial
SOLV-EX CORP. (Nasdaq SmallCap: SOLV) offers a case in point. The
deal was structured so that offshore investors could convert their holdings
into Solv-Ex stock at the lower of two figures: 20% above the market price
on the day the deal closed (i.e. a purchase price of $14.25 per share) or
18% below the average closing price during the five days prior to
conversion. One third of the preferred stock could be converted into
common shares after 45 days, another third after 90 days, and the rest
after 105 days.
Most large sellers try to work their trades to get the best price for their
shares. If Solv-Ex shares didn't immediately rise or show serious prospects
for doing so, these Reg S investors in Solv-Ex actually had a powerful
incentive to engage in sloppy selling to drive down the stock's price. That's
because their cost basis gets lower as the stock falls.
The other rather sad corollary to such deals is that the potential share
dilution is unlimited: the lower the stock price gets, the more shares that
initial investment buys. Some companies have even found themselves in the
bind of having too few shares authorized to cover such conversions. Others
have simply refused to convert the preferred stock into common, claiming
their stock had been manipulated by their Reg S investors.
Consider the case of STARTRONIX INTERNATIONAL (OTC
Bulletin Board: STNX). This "leading provider of Internet-related
products" is being sued by its own Reg S investors. That's because in early
November, the company halted conversion of its privately convertible
preferred. Company officials think their investors were actually
manipulating the company's shares. As StarTronix chief executive Greg
Gilbert told Dow Jones News in late December, "It got so that we could
predict the day when a tranche [of securities] was coming in [to be
converted] because our stock would drop 20%" just beforehand.
George Sandhu is an officer with Baytree Associates Inc., the New
York-based private placement firm that has been doing Reg S deals since
1990. His company underwrote the deal for StarTronix. He argues that this
deal soured mainly because the company's representations to his firm
"weren't exactly truthful."
He said StarTronix couldn't even meet the next week's payroll when
Baytree came to them. "You tell me whether it's in the benefit of
shareholders to rescue a company and give it some life," Sandhu said. "I
think it was in the benefit of them. And I don't think the company has acted
correctly. The stock did not fall because of anything that investors did. I
think on the other side of it, the company was trying to do other things
besides really make this product work... I think they were more interested
in where their stock was going than where their products were going."
Sandhu said the that if you really looked at the trading pattern of
StarTronix's stock, there's no basis to believe that the Reg S investors
destroyed it. StarTronix attorney Ken Bloom of Gartner & Bloom could
not be reached for comment.
Sandhu added, however, that the proposed rule changes won't hurt
Baytree's business. "To us Regulation S was just a way that made it simpler
and easier to distribute stock to overseas investors.... Even without
Regulation S, our business will continue." He said that the company usually
works with mid-size companies and that the StarTronix deal was Baytree's
first private placement for a firm listed on the OTC Bulletin Board.
He pointed out, though, that deals are structured based on the risks
involved. "You can structure deals that don't incentivize the investor to take
the stock down. When you're dealing with companies that are larger and of
better quality, you usually structure a deal so that you don't allow that to
happen." He said that restricting sales of Reg S securities to a year or more
will effectively increase the cost of capital for small companies that continue
to do such deals. "Now if someone's got to hold for a year, an investor
might ask for a larger discount or some other thing that makes it more
cost-prohibitive to the small company."
Of course, one could argue that some companies don't merit further public
financing and that, in any case, the rules for private placements under
Regulation S ought to allow current shareholders to know what's going on
if their equity is about to be diluted.
It's not clear whether the new SEC proposals will completely resolve all the
problems associated with Reg S offerings even if they are passed in the
present form. Indeed, the numerous questions posed by the Commission in
the documents currently available for public comment show the SEC is
anxious to close loopholes that lead to manipulation while at the same time
making sure that the new rules are not unnecessarily onerous.
Still, the SEC seems prepared for real changes. The proposals call for
eliminating the recently imposed rule that requires companies to file a Form
8-K within 15 days of a Reg S offering. Companies could now simply
report that information in the quarterly 10-Q filing. But -- and this is a huge
improvement over the existing law -- the sale of equities offered under Reg
S could not be resold into the U.S. market for at least one year, possibly
two years.
That's because the Commission has proposed treating these Reg S equities
like other restricted securities that fall under Rule 144 of the securities laws.
The SEC has simultaneously suggested that the holding period for such
securities should be dropped from two years to one year. Under this new
proposal, then, the investment community will lose in terms of the timeliness
of disclosure, but the longer holding period means the shares can't be
almost immediately flipped into the market.
The Commission will also place new restrictions on hedging activity
associated with Reg S offerings, but it seems to believe that changing the
holding period is the crucial element in discouraging speculation and market
manipulation. "Maintaining a hedge for one or two years, as opposed to 40
days, is more costly and may be impossible for many of the illiquid
securities sold in abusive cases," the proposal argues.
The new proposals also indicate that the use of promissory notes is
inconsistent with the intent of Regulation S to allow companies to raise
capital from overseas investors. But the proposals remain rather tentative
both in regard to promissory notes and to the troubling issue of convertible
equities. On the one hand, the Commission is "aware that many Regulation
S abuses have involved the use of convertible or exchangeable securities or
warrants." But as the proposal points out, many companies "legitimately
offer under Regulation S either convertible or exchangeable debt securities,
or warrants for common stock as a unit with other securities, to lower their
costs of capital."
J. William Hicks, securities law professor at Indiana University Law School
in Bloomington, thinks the SEC is on the right track. Hicks literally wrote
the book on Resales of Restricted Securities, and he has long been critical
of the loopholes offered by Regulation S.
"I've been critical right from the beginning and actually recommended, as
soon as there was some indication that there was going to be abuse, that
they treat these [securities offered under Reg S] as restricted securities," he
said. "When I made that recommendation in my book, I really didn't think
that it was likely to be embraced just because the trend seemed to be in the
opposite direction," toward a market-driven system where the SEC would
just step out of the way. "But I think they've suddenly realized that there are
far more abuses than they anticipated and that the seriousness of these
abuses are such that they need to be a little bit tougher."
Still, Hicks indicated that most of the cases involving Reg S that have been
serious enough to attract government action or journalistic scrutiny involve
more than mere registration problems. They involve violations of federal
anti-fraud provisions of the securities law.
"So you've got a lot of misleading press releases that are blowing up the
price back home to handle that influx of those securities," he said. "That, to
me, is still going to remain a problem. What the SEC is doing with this is
just removing one of the very strong incentives for taking advantage of this
kind of loophole."
Hicks is optimistic that the proposed changes will help. He also said that he
doesn't think legitimate companies will be hurt by the new requirements
since qualified institutional investors that participate in the private offerings
conducted by larger companies generally are making long-term
investments. Still, he's realistic.
"It seems to me that no matter how creative regulators are, and I think this
was a very creative move on the part of the SEC to come up with Reg S...
the creativity and imagination of those that don't want to follow the rules
seems equal to it."
Though Rogue has often been critical of Barron's, it's clear that the weekly
financial paper has done yeoman work in keeping up with those taking
advantage of Regulation S. Jaye Scholl and other Barron's reporters have
in the last year offered a number of first-rate exposes into how some
companies and investors have abused this relatively arcane rule. The new
SEC proposal actually cites these articles in footnotes.
One issue lurking at the edge of the proposed rule changes is the larger
matter of whether the SEC is, even now, as sensitive to issues of corporate
disclosure as it should be. With the increased access to online
communications, the time may be ripe for investors to ask for all private
placements to be accompanied by a contemporaneous notification from the
issuing company. Even if the shares are restricted, don't all investors have a
right to know when the companies they own plan to sell more shares?
The SEC is currently accepting comments on the proposed rule changes.
Letters should be submitted in triplicate form to Jonathan G. Katz,
Secretary, U.S. Securities and Exchange Commission, 450 Fifth Street,
N.W., Washington, D.C. 20549. Online investors might find it easier to
submit letters electronically to <rule-comments@sec.gov.> Comments sent
by e-mail will be posted on the SEC's Web site. |
