CURRENT DEVELOPMENTS IN EQUITY FINANCING FOR HIGH TECH START-UP COMPANIES
FRANCHISORS FACE NEW REGU-LATIONS AND A RISING WAVE OF FRANCHISEE DISCONTENT

As Published in the Orange County Business Journal, March 28, 2000
© David M. Griffith

By David M. Griffith, Esq.

Introduction

In the first quarter of 1999 the Securities and Exchange Commission (SEC) and the National Association of Securities Dealers (NASD) enacted wide sweeping changes to rules that had governed 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). Such securities could begin trading like any other exchange listed security in a relatively short period of time after the conclusion of the offering, subject only to the approval by the NASD of the company market maker’s Form 211 application to commence trading in the stock.

For several years the SEC had been concerned about perceived fraud in the “microcap” market, defined as issues trading on the OTCBB and representing about $20 billion in annual stock sales. Incidence of reported fraud in the market were increasing. Typical schemes involved inflation of the trading price of an issuer’s stock through distribution of misleading publicity or other market manipulation 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. These companies typically had minimum capitalization, low share prices, limited public information available to prospective investors, and little or no analyst coverage.

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

In May 1998 the SEC issued Release No. 33-7541, announcing a proposed amendment to Rule 504 of Regulation D that would result in securities being sold under Rule 504 being deemed “restricted” securities which were not freely tradable upon issuance. The stated purpose of the proposed rule change was to eliminate the ability of certain market participants to rapidly resell stock after an artificial inflation of the stock price. On February 25, 1999 the SEC issued Release No. 7644 adopting amendments to Rule 504 which became effective April 7, 1999. This release modified Rule 504 to limit 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. These securities may only be resold after the one-year holding period of the SEC’s Rule 144 (and then only pursuant to the terms of that rule), through registration, or through another exemption (such as Regulation A), if available.

Registration of Rule 504 Offerings in California

The 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 the amended Rule 504 exemption. The 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. In addition, the issuer must file historical financial statements prepared in accordance with generally accepted accounting principles in the United States. The disclosure document must be delivered before sale to all purchasers. Registration of an offering outside of California, and subsequent attempted sales to California residents, would not meet the public offering requirements of amended Rule 504.

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 presently 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. The proposed California version of the MAIE would permit solicitations up to $1,000,000 as long as the offering were sold only to accredited investors.

Amended OTCBB Rules – Reporting Company Requirement

On January 4, 1999 the Securities and Exchange Commission (SEC) approved amendments to the National Association of Securities Dealers, Inc. (NASD) Rules to limit quotations on the OTC Bulletin Board (OTCBB) to the securities of companies that report their current financial information to the SEC, or are “reporting companies” within the meaning of the 1934 Securities Exchange Act. The OTCBB is a service provided by the NASD that displays real-time quotes, last-sale prices and volume information for domestic securities. The OTCBB is unlike NASDAQ or other listed exchanges like the New York or American Stock Exchanges where companies must apply for listing approval and thereafter meet certain continued listing requirements. Instead of the individual companies themselves initiating listing on the OTCBB, either brokerage firms or market makers apply to have the companies quoted on the OTCBB.

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 until January 1999 did not file public reports. The implementation of amended Rule 6530 was phased in on an alphabetical basis with the first compliance group deadline in July 1999 and the final group deadline being set at June 2000. Once an OTCBB issuer is delinquent in filing with the SEC any required reports, they will have a 30 day grace period to file the required reports. After the grace period, quotations in the securities of the delinquent reporter are no longer allowed on the OTCBB. If a security becomes ineligible for the OTCBB broker-dealers may still publish or submit 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’s OTC Compliance Unit to allow the issuer’s securities to be cleared for quotation on the OTCBB. SEC Rule 15c2-11n (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. The broker-dealer must also have a reasonable basis for believing that the issuer information, when considered along with any supplemental information, is accurate and is from a reliable source.

In February 1998, the SEC published for comment amendments to the Rule that were designed to curb fraud in microcap securities. After receiving a significant response from the public the SEC issued a revised proposal last summer which has not yet been enacted. The revised Rule is intended to have broker-dealers "stop, look and listen" before they begin to quote an OTC security on the OTCBB. The SEC has recommended that Rule 15c2-11 now be interpreted to eliminate the Rule's provision that allowed broker-dealers to rely on other broker-dealer’s investigation and require all broker-dealers to review current issuer information before publishing priced quotations for a security. Such firms would have to review current information about the issuer annually and upon the occurrence of specified events. 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 likely more stringent requirements of SEC Rule 15c2-11 that are probable in the near future.