Introduction
In January 1999 the Securities and Exchange Commission (SEC) and the National Association of Securities Dealers (NASD) enacted wide sweeping changes to the way that many smaller technology companies had raised capital through most of the 1990s. Previously, companies had been allowed to utilize Rule 504 of the SEC’s Regulation D to raise up to $1,000,000 in equity capital through public sales of these securities. These companies were also able to issue “free trading” securities that could be listed on the NASD’s Over-The-Counter Bulletin Board (OTCBB). The OTCBB is a service provided by the NASD that displays real-time quotes for domestic securities. Such securities could begin trading like any other exchange listed security in a short period of time after the conclusion of the offering, subject only to the approval by the NASD of the company’s application to commence trading in the stock.
For several years the SEC had been concerned about perceived fraud in the OTCBB “microcap” market. Typical schemes involved inflation of the trading price of an issuer’s stock through distribution of misleading publicity known as “pump and dump,” where the stock price drops sharply after the publicity event. The SEC was confronted with numerous cases where the Internet was being used to launch nationwide Rule 504 offerings for securities of non-reporting companies that were once thought to be local companies.
To combat these developments, the SEC in conjunction with the NASD, took the following steps: (a) they amended Rule 504 to eliminate the free tradability of recently issued securities unless a state registration had been achieved or the shares were sold strictly to “accredited” investors; (b) they limited the availability of the OTCBB for trading securities to those companies that had become “reporting” companies under the Securities and Exchange Act of 1934; and (c) they proposed substantially tighter controls over the ability of broker-dealers to make a market in microcap stocks until they had performed a substantial due diligence review of the stocks they were promoting.
Amended Rule 504
The amendments to Rule 504 became effective April 7, 1999. Rule 504 now limits the circumstances where “public” or general solicitation is permitted and freely tradable shares may be issued in reliance on the rule to transactions (a) registered under state law and requiring public filing and delivery of a disclosure document to investors before sale; or (b) exempted under state law permitting general solicitation and advertising as long as sales are made only to accredited investors. Sales of securities under modified Rule 504 may still be made to investors without observing the foregoing requirements, but general solicitation is not allowed and the issued securities are “restricted” and not free trading.
Registration of Rule 504 Offerings in California
Amended Rule 504 is substantially similar to its pre-1992 format, where state registration was required. Form U-7, also known as the small corporate offering registration (SCOR) may be used for companies registering securities in California for public sale when relying upon amended Rule 504. Form U-7 contains a series of detailed questions on the issuer’s business, intended use of proceeds, management, principal stockholders, and plan of distribution and requires financial statements prepared in accordance with “GAAP.”
California’s Proposed Adoption of an Accredited Investor Exemption
Presently, the only method for complying with amended Rule 504 is state registration of the proposed offering, because California does not currently have an accredited investor exemption meeting the amended Rule 504 requirements. Section 25102(n) of the California Corporations Code, known as the “qualified purchaser exemption,” does not satisfy the new requirements because of its lower income and net worth requirements. 35 states have adopted the so-called Model Accredited Investor Exemption (MAIE) which does meet the new Rule 504 requirements. Generally, the MAIE exempts offers and sales of securities from state registration if 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. The California Capital Formation and Business Investment Committee is expected to introduce a broader version of the NASAA MAIE in the 2000 legislative session.
Amended OTCBB Rules – Reporting Company Requirement
In January 1999 the SEC approved amendments to NASD Rule 6530 to limit quotations on the OTCBB to securities of “reporting companies.” Prior to the amendment of NASD Rule 6530 there was no requirement for an issuer quoted on the OTCBB to make current publicly available SEC reports, and over half of the 6,500 companies quoted on the OTCBB did not file public reports. The requirement for all OTCBB companies to file public reports was phased in with the final deadline being set at June 2000. If a security becomes ineligible for the OTCBB, broker-dealers may still publish quotations in other quotation mediums, including the National Quotation Bureau’s Pink Sheets.
Rule 15c2-11 Compliance
In addition to becoming a reporting company, an issuing company must enlist a broker-dealer firm to act as its “market maker” and file a Form 211 with the NASD to allow the issuer’s securities to be quoted on the OTCBB. SEC Rule 15c2-11 (the “Rule”) contains requirements that are intended to deter broker-dealers from initiating quotations for OTC securities that may facilitate a fraudulent or manipulative scheme. The Rule currently prohibits a broker-dealer from publishing a quotation for an OTC security on the OTCBB unless it has obtained and reviewed current information about the issuer believed to be accurate and is from a reliable source. The SEC has proposed to revise this Rule to promote further curbs on microcap fraud by eliminating the existing provision that allows broker-dealers to rely on another broker’s investigation and requiring all market makers to review current issuer information before publishing priced quotations for a security. The amendments would exclude from the Rule’s coverage: (a) securities with a worldwide average daily trading volume value of at least $100,000 during each month of the six full calendar months immediately preceding the date of publication of a quotation; (b) securities with a bid price of at least $50 per share; and (c) securities of issuers with net tangible assets in excess of $10,000,000.
Conclusion
Until California adopts its own version of the Model Accredited Investor Exemption, start-up high tech companies desiring to utilize amended SEC 504 to issue free-trading shares that can be sold on the OTCBB will have to register their offering with the California Department of Corporations and also become a public “reporting company” after the completion of the offering. Additionally, such issuers will have to enlist the services of a broker-dealer willing to comply with the more stringent requirements of SEC Rule 15c2-11 that are probable in the near future.
David M. Griffith is a securities specialist to Kring & Brown, in their corporate and technology department. Mr. Griffith specializes in advising clients on corporate finance matters including mergers and acquisitions, private placements and initial public offerings.
Kring & Brown, LLP is located at 38 Corporate Park, Irvine, California, 92660, (949) 261-7895. Kring & Brown has offices in Irvine, Ontario, San Diego, Las Vegas, Nevada and Phoenix, Arizona. Kring & Brown paid for this space and is solely responsible for its contents.
