Regulation S Abuses
In Feb., 1998, the SEC published a revision to Regulation S designed to curb the abuses of the reg in microcap stocks. The principal change was to make Reg S stock restricted stock under rule 144 thereby increasing the restriction period from the prior 40 day period to one year. The changes went into effect on April 27, 1998 except for changes in reporting requirements which are effective on Jan. 1, 1999. Further details can be found in:
sec.gov and
sec.gov
The abuses which prompted this change have been quite varied, but a common feature has been that they used Reg S as a means to sell unregistered stock which eventually and inevitably ended up in the U.S.* Buried in the footnotes of the final rule are some examples which illustrate the abuses in question and make for interesting reading:
1. Use of Reg S stock acquired at a discount coupled with a simultaneous short sale to lock in a large and essentially risk free profit after the 40 day holding period elapses:
The dealings of the GFL Ultra Fund as recounted in sec.gov provide a classic example. Here's how it worked according to the SEC in the case of Zitel:
GFL Ultra Fund Ltd.'s trading in the securities of Zitel Corporation ("Zitel") is an example of how the strategy operated. The Fund purchased 300,000 Regulation S shares from Zitel on December 12, 1994 at a discount of approximately 15% to the freely tradeable share price. The Fund partially hedged these Regulation S shares by selling short 279,800 shares in five brokerage accounts between November 14, 1994, and January 19, 1995, in connection with this purchase of Regulation S shares. The Fund locked in a profit (the differential between the price at which the 279,800 shares were sold short net of commissions and the price at which the 279,800 Regulation S shares were purchased) of $816,430.75.<(5)> By February 7, 1995, the Fund had distributed all of its Zitel Regulation S shares into the United States markets and had closed out all of its Zitel short positions with purchases in the open market.
Note that the discount in the case cited was a "mere" 15% in comparison with the AZNT's discount which apparently was somewhere between 60% and 81%,
2. Use of promissory notes for the purchase of the Reg S shares with the expectation that the loan will be repaid from the proceeds of the sale of the securities after 40 days:
Here's an example:
In the matter of Candie's, Inc., Response USA, Inc., Salvatore Mazzeo and Schneck Weltzman Hashmall & Mischel):
... FINDINGS
This matter involves four offerings of securities purportedly made in reliance on Regulation S promulgated under the Securities Act of 1933. In fact, as discussed below, the offerings involved schemes to evade the registration requirements, and therefore did not constitute offers and sales of securities outside the United States for purposes of Regulation S. All four offerings at issue in this matter were arranged and structured by respondents Schneck Weltman, a New York law firm, and Salvatore Mazzeo, the president of Westfield Financial Corp., a now defunct broker-dealer.
In all four offerings, the only liquid market for the securities was in the United States. In each instance, a large block of securities was sold at a substantial discount to the prevailing market price in return for a short-term, unsecured promissory note. The respondents knew almost nothing about the foreign purchasers. Candies, Response, and Schneck Weltman had no contact with the foreign purchasers, and Mazzeo (the only respondent who had even indirect contact with the foreign purchasers) dealt solely with their representative, an attorney who resides abroad. The respondents did not know whether the foreign purchasers could afford to pay off the promissory notes, and made no inquiry into their ability to pay. In each instance the securities were transferred to the newly opened Westfield accounts of the foreign purchasers. Shortly after the expiration of the 40-day restricted period of Regulation S, Mazzeo sold the securities to U.S. customers of Westfield. In all four of the transactions, the foreign purchasers bore very little market risk because they used the proceeds from the U.S. sales to pay off their promissory notes. In essence, the foreign purchasers acted as mere conduits for the sale of unregistered securities in the United States.
sec.gov
3. Inevitably some will be extremely flexible in their definition of "offshore transaction":
According to the complaint, the scheme began when stock promoter Sung and Arthur Feher, Jr., the now-deceased former president of Members, obtained 1.4 million shares of unregistered Members stock in sham transactions designed to circumvent the registration provisions of the federal securities laws. In one transaction, Feher allegedly caused Members to issue 200,000 shares to his nominee, a 96-year-old retired nursemaid who lived with him in Florida. In an effort to invoke Regulation S, which provides exemption from registration for sales made abroad, Feher allegedly caused Members to issue the stock to the woman as payment for consulting services that she had not performed, and moreover caused records to reflect that she lived abroad. The complaint alleges that the unregistered stock was deposited in nominee accounts at Union Securities in Vancouver, British Columbia, where Gilbert worked as a stockbroker.
sec.gov
Feher, who was convicted under an indictment arising from the same scam, also caused Members to issue stock to seven Bahamian companies that he controlled. The stock was subsequently sold into the U.S. market for approximately $5.5 million according to the SEC.
sec.gov
Also in the "extememe flexibility" category for a variety of reasons if the SEC allegations are correct, is the following:
... The third case involves attempts to stage live performances of American Gladiators. The SEC alleges that Chariot Entertainment violated various provisions of federal securities law in its attempts to finance the American Gladiators stage shows outside a Las Vegas hotel. The shows were never produced. Chariot sought to go public by merging with a shell company listed on NASDAQ. To meet NASDAQ listing requirements, the defendants developed and executed a scheme to acquire $5 million in certificates of deposit, ostensibly issued by a Russian bank, but in reality created at a Kinko's copy shop in Florida. Chariot was to finance acquisition of the CDs through the sale of newly issued stock which superficially met the requirements of Regulation S, but which was actually issued to a California corporation. Finally, Chariot failed to disclose that it violated its lease agreement with the Las Vegas hotel by failing to obtain a performance bond and to make required payments.
sec.gov
(See sec.gov for further details.)
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* From a SEC release discussing problematical practices under Regulation S (Release 33-7190) which appeared in the Federal Register on July 10, 1995:
... 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. ...
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