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 <email@example.com.> Comments sent by e-mail will be posted on the SEC's Web site.
--Louis Corrigan (RgeSeymour@aol.com)
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