Securities and Exchange Commission
DIVISION OF CORPORATION FINANCE

CURRENT ISSUES AND RULEMAKING PROJECTS

VIII. CURRENT DISCLOSURE, LEGAL AND PROCESSING ISSUES

NOVEMBER 14, 2000

    A. Disclosure, Legal and Processing Issues

        1. Disclosures about "Targeted Stock"

            a. Overview

Some registrants have issued classes of stock that they characterize as "targeted" or "tracking" stock because they are referenced in some manner to a specific business unit, activity or assets of the registrant. The staff is concerned that the style and content of disclosures about the operations referenced by a class of common stock may give the inaccurate impression that the investor has a direct or exclusive financial interest in that unit.

Notwithstanding the title given to a particular class of stock, an investor in any of a registrant's classes of common stock has a financial interest only in the residual net assets of the registrant, allocated among the shareholder classes in accordance with the formulae stipulated in the corporate charter. Assets and income attributed to units referenced by each class typically are available to all of the registrant's creditors, and even other classes of shareholders, in the event of liquidation. While dividends declared on each class may not exceed some measure of the performance of the referenced business unit, no dividends need be declared at all. Moreover, the dividend declaration policies typically are subject to change and need bear no relationship to the relative performance of the referenced businesses. Methods and assumptions that can significantly affect measurement of the referenced unit's performance typically can be changed at any time without the consent of the security holders.

b. Characterizations of the security as
"tracking" a business unit

If no term of the targeted stock requires or assures that potential distributions will correlate with the performance of the business unit nominally associated with the security, implications that the market value of the security will "track," or is otherwise linked with, a business unit are subject to challenge. The staff has asked registrants to explain in their filings why the formula for determining the amount available for dividends (or any other term or feature of the security) can be expected to link in some fashion the market value of a class of common stock with the value or performance of any subpart of the registrant, or state clearly that management does not intend to imply such a linkage.

c. Recommended approach to disclosure about targeted stock

While the staff encourages robust disclosure about the registrant's operating segments, presenting information about the referenced businesses as if distinct from the registrant may confuse investors about the nature of the security. We believe companies should integrate discussions and quantitative data about the referenced business units more closely within a comprehensive discussion of the registrant's financial condition and operating results. While schedules or condensed financial information demonstrating the calculation of earnings available for each class of the registrant's common stock are relevant, more extensive presentations can be misunderstood and should be reconsidered. If a company chooses to present more than condensed financial data, the staff has recommended that companies present no greater detail than "consolidating financial statements" that include the referenced businesses together with the financial statements of the registrant. That presentation would show explicitly how management and the board have allocated and attributed revenues, expenses, assets, liabilities, and cash flows, but will not necessarily reflect earnings applicable to the different classes of stock due to features of the allocation formula that are incompatible with GAAP.

d. Use of separate full financial statements for a referenced business unit

Notwithstanding our recommendation to the contrary, some issuers of targeted stock have chosen to present complete separate audited financial statements of the referenced units. In this case, the staff believes that financial statements of the referenced unit furnished to investors should be accompanied always by financial statements of the registrant, as issuer of the security. Most auditors will permit use of their report on the financial statements of the referenced business only in those circumstances. EPS of one class of stock should not be presented alone or within the separate financial statements of the referenced business security because that business did not issue the security. EPS with respect to any class of the issuer's securities should be presented only with the issuer's consolidated financial statements or with its related consolidated information.

e. Consequences of formula-based financial statements

In some cases, separate financial statements presented in an issuer's filing do not appear to be an actual business or division, but rather an elaborate depiction of the earnings allocation formula for a class of stock, as if those legal terms defined an accounting entity. For example, sometimes that formula results in the depiction of one of the issuer's businesses as if it had a financial interest in another of its businesses. Financial statements prepared in accordance with the dictates of management, the board and the corporate charter for the purpose of measuring earnings available to a class of shareholders do not necessarily present fairly the financial condition, cash flows and operating results of an actual business unit within the registrant.

The staff has raised a number of questions in these circumstances: Do financial statements based on these formulae comply with GAAP? Does the association of the auditor with these presentations give unwarranted comfort to investors about the fairness to the different shareholder groups of management's assignment of revenues and expenses and its allocation of capital and other costs? Are the financial statements "special purpose" financial statements that are prepared on a basis of accounting prescribed in a contractual agreement, requiring special considerations for disclosure and auditor association?

f. Non-GAAP measures of performance

In some cases, the terms of the targeted stock stipulate explicitly that the performance of the unit will be measured on a basis that departs from GAAP. Any measurement, classification, allocation or disclosure that departs from GAAP but is necessary to measure or explain amounts available for dividends on stock referenced to the unit should be depicted separately from presentations that are purported to be in accordance with GAAP. An amount should not be labeled as "net income" unless it is calculated in accordance with GAAP. If the financial statements of the unit are purported to be in accordance with GAAP, management should ensure that all information essential for a fair presentation of the entity's financial position, results of operations, and cash flows in conformity with GAAP is set forth in the financial statements. Failure to include all such information should result in a qualification of the auditor's report on the unit's financial statements.

g. Cost allocations

The units referenced by the targeted stock may share many common costs, such as general and administrative and interest costs. As required by SAB Topic 1B, a complete description of any allocation methods used for cash, debt, related interest and financing costs, corporate overhead, and other common costs should be provided in the notes to the financial statements that purport to be prepared in accordance with GAAP. The amounts likely to be reported by the entity were it a stand-alone entity should be disclosed. In some cases, the staff has questioned whether allocations have been biased. For example, operating results and EPS of operations that are valued on the basis of earnings could be unfairly inflated as a result of excessive allocations of common costs to operations that are valued on the basis of revenue growth. If the methodologies and assumptions underlying the allocations of debt and corporate expenses may change without security holder approval, that fact should be stated clearly. If the financial statements of the business unit before and after the issuance of the tracking stock will not be comparable, that fact should be disclosed. On occasion, the staff has questioned whether a change in the method of attributing revenue or expense from one shareholder group to another would be reported as a change in reporting entity or, if deemed a change in estimate or principle, how the auditor will determine whether a change is a "better" method of calculating earnings attributable to a particular shareholder group.

h. Other disclosure issues

Other areas of disclosure that are of particular significance for issuers of targeted stock include the following:

Policies for the management of cash generated by and capital investment in the referenced units, and for the pricing of "transactions" between the referenced units.

Conflicts of interest.

Effects of corporate events (mergers, tender offers, changes in control, adverse tax rulings, liquidation) on rights of the security holders.

Terms under which one class may be converted into another class.

Effects of changes in relative market values of the registrant's outstanding classes of stock on rights of the security holders.

2. "Blank Check" Companies

Where a reporting "blank check" company, as defined in Rule 419(a)(2) of Regulation C, merges into a non-reporting operating company, Rule 12g-3(a) is not available unless complete audited financial statements of the operating company, as well as pro formas, are provided at the effective date of the "succession transaction." This information should be filed under cover of Form 8-K. For additional information concerning "back door" registration on Form 8-K, see National Association of Securities Dealers (April 7, 2000) at
www.otcbb.com/news/EligibilityRule/8kreg.stm. For Section 5 issues related to "blank check" companies, see NASD Regulation, Inc. (January 21, 2000) located in Section X.E. of this outline. See also Rule 419 of Regulation C, which applies generally to offerings by "blank check" companies.

    3. Syndicate Short Sales

        a. What are "syndicate short sales"?

In a registered IPO or follow-on offering of equity and equity-related securities, the Agreement among Underwriters customarily will authorize the lead manager to sell securities in excess of the number of securities included in the firm commitment underwriting for the account of the syndicate. This "syndicate short position" could include:

a "covered" short position equal to the securities registered to cover the underwriters' option to purchase additional securities from the issuer --this option to purchase additional shares is called the "overallotment option" or "green shoe," and

a "naked" short position equal to a specified percentage of the securities included in the firm commitment underwriting --the AAU specifies the extent of the permissible naked short.

The "covered" short position customarily is 15% of the amount of the firm commitment underwriting. This limit is related to the limit on the size of the overallotment option set forth in National Association of Securities Dealers rules. In recent years, the "naked" short position has customarily been up to either 15% or 20% of the amount of the firm commitment underwriting. The size of the "naked" short position is not addressed in the NASD rules.

b. When is a syndicate short position established and how is it covered?

The short position is created at the same time securities in the firm commitment underwriting are allocated --after effectiveness and pricing of the transaction. The syndicate short shares are sold at the public offering price. All purchasers of securities sold by the underwriting syndicate receive final prospectuses and identical forms of Exchange Act Rule 10b-10 confirmations reflecting the prospectus delivery requirement. No distinction is made between the firm commitment and short sale securities on the books and records of the underwriters, the transfer agent or any clearing agency. For all intents and purposes, the syndicate short shares are indistinguishable from all other shares sold under the registration statement.

The decision to create a syndicate short position (both "covered" and "naked") is made by the lead manager, in its sole discretion, at the time of pricing. Most offerings have a short position at least equal to the underwriters' overallotment option or "green shoe." The decision to exercise the green shoe to cover a syndicate short position, if any, must be made within the period specified in the Underwriting Agreement, typically 30 days. The green shoe is often exercised almost immediately in transactions that trade at price levels significantly in excess of the public offering price in order to obviate the need to have a second "closing" with respect to the green shoe shares. However, in some transactions the decision to exercise the green shoe is not made until nearly the end of the 30-day period.

While there is usually a covered syndicate short, the creation of a naked syndicate short is less common. The naked short is more likely to be created in a transaction where the lead manager has reason to be concerned that the supply of securities offered for sale in the secondary market after the commencement of trading in the securities will significantly exceed the demand to purchase such securities, thereby creating downward pressure on the price of the securities that could adversely affect the investors who have purchased in the offering. These concerns may be based on the volatility of the overall market or the level or quality of demand for the securities being offered. The level or quality of demand refers to the ratio of indications of interest or conditional offers to the number of securities being offered and the extent to which the lead manager perceives that if the buyers receive allocations of securities they will be long term holders of all or a significant portion of those securities.

The "naked short shares" are delivered and paid for by investors at the same time as the firm commitment and covered short shares. In order to deliver the naked short shares, the underwriters may borrow shares which, in the case of an IPO, may be shares issued in the offering. In a follow-on offering, the underwriters may borrow either shares that were issued in the offering or shares that were outstanding before the offering. The syndicate bears the cost of borrowing those shares.

c. What prospectus disclosure is required with regard to the syndicate short position and the manner in which it is covered?

The fact that the underwriters may make short sales and may engage in short covering transactions must be disclosed in the "Plan of Distribution" or "Underwriting" section of the prospectus. The staff will raise comments if this disclosure does not address the following material points regarding any applicable short sale transactions. The disclosure may use the language set forth following each point or may be in other clear, plain language.

The potential for underwriter short sales in connection with the offering --for example, the disclosure may state: "In connection with the offering, the underwriters may make short sales of the issuer's shares and may purchase the issuer's shares on the open market to cover positions created by short sales."

What short sales are --for example, the disclosure may state: "Short sales involve the sale by the underwriters of a greater number of shares than they are required to purchase in the offering."

What covered short sales are --for example, the disclosure may state: "' Covered' short sales are sales made in an amount not greater than the underwriters' 'overallotment' option to purchase additional shares in the offering."

How underwriters close out covered short sale positions --for example, the disclosure may state: "The underwriters may close out any covered short position by either exercising their overallotment option or purchasing shares in the open market."

How underwriters determine the method for closing out covered short sale positions --for example, the disclosure may state: "In determining the source of shares to close out the covered short position, the underwriters will consider, among other things, the price of shares available for purchase in the open market as compared to the price at which they may purchase shares through the overallotment option."

What naked short sales are --for example, the disclosure may state: "' Naked' short sales are sales in excess of the overallotment option."

How underwriters close out naked short sale positions --for example, the disclosure may state: "The underwriters must close out any naked short position by purchasing shares in the open market."

When a naked short position will be created --for example, the disclosure may state: "A naked short position is more likely to be created if the underwriters are concerned that there may be downward pressure on the price of the shares in the open market after pricing that could adversely affect investors who purchase in the offering."

The potential effects of underwriters' short sales and underwriters' transactions to cover those short sales --for example, the disclosure may state: "Similar to other purchase transactions, the underwriters' purchases to cover the syndicate short sales may have the effect of raising or maintaining the market price of the [issuer's] stock or preventing or retarding a decline in the market price of [issuer's] stock. As a result, the price of the [issuer's] stock may be higher than the price that might otherwise exist in the open market."

This disclosure is, of course, in addition to the other disclosure included in that section of the prospectus regarding stabilizing transactions. The disclosure addressing the foregoing points may be combined with that other disclosure.

d. Is the offer and sale of the "naked short shares" registered under the Securities Act?

Yes. It is the Division's view that the offer and sale of all shares in the registered offering are registered under the registration statement. In this regard, "all shares in the registered offering" refers to

the firm commitment shares,

the covered short -or green shoe -shares, and

the naked short shares.

Although the naked short shares are included in "all shares in the registered offering," the number of shares specified on the cover page of the registration statement need only include the number of firm commitment shares and the green shoe shares. The number of shares specified on the cover page of the registration statement is understood to include an indeterminate number of naked short shares up to the extent permitted by the AAU. The "Plan of Distribution" or "Underwriting" section of the prospectus must describe the offer and sale of all shares in the registered offering.

The treatment of the naked short shares on the cover page of the registration statement set forth above differs from the method in which registrants register shares to be sold in "market making" transactions. With respect to "market making shares," the registrant must include an indeterminate number of those shares on the cover page of the registration statement.

e. How do the anti-fraud and civil liability provisions of the federal securities laws apply to the offer and sale of the naked short shares?

In a registered offering, the anti-fraud and civil liability provisions of the federal securities laws apply to the offer and sale of the naked short shares in the same manner as the offer and sale of other shares in that registered offering.

    4. Third-Party Derivative Securities

In Morgan Stanley & Co., Inc. (June 24, 1996), the Division addressed disclosure issues relating to Securities Act Section 5 registered offerings of securities that are exchangeable, on either an optional or a mandatory basis (" Exchangeable Securities"), for the equity securities (or the cash value thereof) of another issuer (" Underlying Securities").

The Division took the position that complete disclosure regarding the issuer of the Underlying Securities is material to investors at the time of both the initial sale of the Exchangeable Securities and on a continuous basis thereafter until the Underlying Securities (or the cash value thereof) have been exchanged for the Exchangeable Securities and other payment obligations on the Exchangeable Securities, if any, have been satisfied. The Division also took the view that this complete disclosure is not required to be set forth in the filings of the issuer of the Exchangeable Securities where there is sufficient market interest and publicly available information regarding the issuer of the Underlying Securities.

The Division stated that sufficient market interest and publicly available information will be deemed to exist where the issuer of the Underlying Securities

has a class of equity securities registered under Exchange Act Section 12; and

is either

eligible to use Securities Act Form S-3 or F-3 for a primary offering of non-investment grade securities pursuant to General Instruction B. 1 of such forms; or

meets the listing criteria that an issuer of the Underlying Securities would have to meet if the class of Exchangeable Securities was to be listed on a national securities exchange as equity linked securities, such as American Stock Exchange Rule 107.B.

The Division also stated that where there is sufficient market interest and publicly available information, as described above, the issuer of the Exchangeable Securities may include abbreviated disclosure about the issuer and terms of the Underlying Securities in its Securities Act registration statement and Exchange Act periodic reports. Abbreviated disclosure in a report is adequate only where there is sufficient market interest and publicly available information at the time the report is filed.

Finally, the Division stated that the abbreviated disclosure would include at least:

a brief discussion of the business of the issuer of the Underlying Securities;

disclosure about the availability of information with respect to the issuer of the Underlying Securities similar to that required by Regulation S-K Item 502(a); and

information concerning the market price of the Underlying Securities similar to that called for Regulation S-K Item 201(a).

EITF Issues Nos. 86-28 and 96-12 address certain aspects of the accounting for third-party derivative securities.

5. Section 5 Issues Arising from On-line Offerings and Related Communications, Including Offers to Buy

Many underwriters have begun using the Internet to offer and sell securities in registered public offerings. These e-brokers post preliminary prospectuses, and sometimes other material, on their web sites and many solicit conditional offers to buy securities rather than the more customary indications of interest.

In connection with our review of registration statements, we have been issuing comments to get information on what procedures the different e-brokers are using to assure compliance with Section 5 of the Securities Act, and specifically, to avoid pre-effective sales of securities violative of Section 5(a). In addition, we have been actively contacting e-brokers to review their procedures outside the context of a particular offering to avoid timing concerns. In our review of the offering procedures of e-brokers, we examine how conditional offers to buy securities are solicited, how and when they are accepted, and how these purchases are funded. To the extent e-brokers take indications of interest, we also check to ensure that they have procedures in place to obtain reconfirmations from customers after effectiveness.

The following discussion principally relates to our experience in examining e-brokers' practices in IPOs. We may issue additional guidance with respect to follow-on offerings as we gain more experience in that area.

a. Communications during the offering process

Before effectiveness, communications on an e-broker's (as well as on the issuer's) web site that make an offer to sell or solicit an offer to buy may only be made by means of a prospectus complying with Section 10 or by communications that come within the safe harbor of Rule 134. Communications that are merely instructional and are not designed to generate interest in a particular offering typically are unobjectionable even if they do not fall within the safe harbor of Rule 134. See, for example, Wit Capital (July 14, 1999), such as general information on how to use the web site, how the brokerage service operates and how to open an account.

b. How the offer and sale of the security are conducted

We want to make sure that each e-broker has procedures in place to assure compliance with Section 5.

i. When may an e-broker take a conditional offer to buy?

We ask e-brokers not to take conditional offers to buy from prospective investors more than seven days before the offer is accepted which acceptance cannot occur until after effectiveness, pricing and a meaningful opportunity to withdraw. If they do take conditional offers more than seven days before acceptance of the offers, the conditional offers must be reconfirmed no more than seven days before acceptance. If the deal is delayed or, for whatever reason, the offer is not accepted within seven days, we ask e-brokers to obtain new conditional offers to buy or to get reconfirmations of the expired conditional offers to buy.

ii. When must an e-broker resolicit a conditional offer to buy from a customer during the seven day period?

E-brokers must notify customers and get new conditional offers to buy or reconfirmations of prior conditional offers to buy if:

there is a material change in the prospectus that requires recirculation;

the offering price range changes pre-effectively; or

the offering prices outside the range.

iii. May customers make conditional offers to buy at a price above the range in the prospectus?

Yes, but we have asked e-brokers to treat these offers as limit orders at the top of the range disclosed in the preliminary prospectus. If the price range changes pre-effectively or the offering prices outside of the disclosed range, customers must be contacted and must reconfirm their offers to buy at the new price.

iv. When may an e-broker accept a conditional offer to buy?

Offers to buy must be conditioned upon the occurrence of each of the following steps and cannot be accepted by e-brokers until each step occurs:

the registration statement is declared effective;

customers are given notice of effectiveness after the registration statement is declared effective (this notice can be before or after pricing);

customers are given a meaningful opportunity --at least one hour --to withdraw their offers to buy between the notice of effectiveness (or notice of pricing) and acceptance of the offer to buy;

the offering must price before offers are accepted;

the offering must price within the customer's range and the range in the preliminary prospectus or the e-broker must receive affirmative confirmations of conditional offers to buy at the revised price; and

customers must be able to withdraw their offers to buy at any time up to notice of acceptance.

v. Before effectiveness, may e-brokers make offers to sell or solicit offers to buy by means of a prospectus that does not comply with Section 10?

No. A preliminary prospectus that omits required information does not comply with Section 10. An offer to sell, a solicitation of an offer to buy, or solicitation of a written indication of interest by means of a prospectus that does not comply with Section 10 would violate Section 5. Similarly, we have taken the position that brokers may not rely on the safe harbor of Rule 134 if a prospectus that complies with Section 10 is unavailable.

The practice of filing the registration statement for an initial public offering without a bona fide estimated offering price range has created concerns with respect to some e-brokers' compliance with Section 5. Because a bona fide estimated range is required in a prospectus used for an IPO, the use of a prospectus without a price range would not comply with Section 5. Similarly, brokers cannot rely on the safe harbor of Rule 134 until the prospectus includes a bona fide estimated range. Therefore, brokers should be careful when communicating in writing before a prospectus that complies with Section 10 is available, and take appropriate steps to ensure that no such communications constitute an "offer" within the meaning of Section 2(a)(3).

vi. May e-brokers require customers to certify that they have read the prospectus?

No. We have found that some e-brokers require prospective investors to certify that they have read the prospectus before these investors can give indications of interest or make conditional offers to buy. This is not acceptable because the issuer, underwriters and brokers may not use language that could induce investors to believe that they have waived any rights that they have under the securities laws. We would not object, however, to language that encourages investors to read the prospectus, but that does not require investors to certify that they have read the prospectus. In addition, we have not objected when brokers ask for certification that investors have accessed or received the prospectus.

c. Payment of the purchase price

We also want to make sure that e-brokers do not require any part of the purchase price to be paid before effectiveness. We have not objected when brokers have required new customers to make a small deposit in order to open an account, but this amount cannot be tied in any way to the purchase price of the securities. In most cases, this amount is $2,000. Funds in the account must remain in the control of the customer at least until his or her conditional offer to buy is accepted after effectiveness and pricing. Also, funds in any account cannot be earmarked for the purchase of securities in any particular offering before effectiveness.

We have found that the procedures followed by individual e-brokers vary from firm to firm. The Wit Capital no-action letter (July 14, 1999) describes only one set of acceptable procedures. These are not the only procedures that may be acceptable and e-brokers do not need to follow Wit Capital in order to comply with Section 5.

    6. Presentation of live electronic auctions

        a. Interpretive letters

Three interpretive letters address "live" online auctions in offerings registered under the Securities Act. W. R. Hambrecht & Co. (July 12, 2000), Wit Capital Corporation (July 20, 2000) and Bear, Stearns & Co., Inc. (July 20, 2000) describe systems by which the underwriters will conduct auctions on the Internet and allow investors to view the auction as they progress. The auctions follow the effectiveness of the registration statement.

b. Concern that the auction screens would be non-conforming prospectuses

The auctions establish the price that investors will pay for the securities. Because price is an important factor in a decision to buy a security, the presentation of the live, transparent auction created the concern that the auction screens would be offers to sell or solicitations of offers to buy the securities within the meaning of Section 2(a)(3) of the Securities Act. A written offer for a security is a prospectus as defined by Section 2(a)(10). Section 5(b)(1) prevents the use of any prospectus not allowed by Section 10 of the Securities Act. The auction screens would not, by themselves, comply with Section 10. Therefore, as permitted by Section 2(a)(10)(a), they could only be used if they were accompanied or preceded by a final prospectus that complies with Section 10(a) of the Securities Act. This is not possible, as the price has not yet been determined at the time of the auction presentation and, therefore, there cannot yet be a final prospectus that complies with Section 10(a).

c. Inclusion of the auction screens as part of the electronic prospectus

To resolve the issue under Section 5(b)(1), the electronic auction presentations described in the letters are made part of a prospectus permitted by Section 10. The letters state that the auction screens must be made accessible only "through" the electronic prospectus. This means that an investor would be able to access the auction screens only by entering the electronic prospectus and clicking a button from within the prospectus that leads to the auction. This method makes the auction screens part of the electronic prospectus and is consistent with the guidance the Commission gave in the electronic media release. Securities Act Release No. 7856 (April 28, 2000). In the release, the Commission stated that

"Information on a web site would be part of a Section 10 prospectus only if an issuer (or person acting on behalf of the issuer, including an intermediary with delivery obligations) acts to make it part of the prospectus. For example, if an issuer includes a hyperlink within a Section 10 prospectus, the hyperlinked information would become a part of that prospectus. When embedded hyperlinks are used, the hyperlinked information must be filed as part of the prospectus in the effective registration statement and will be subject to liability under Section 11 of the Securities Act. In contrast, a hyperlink from an external document to a Section 10 prospectus would result in both documents being delivered together, but would not result in the non-prospectus document being deemed part of the prospectus."

Access to the auction screens from a hyperlink within the electronic prospectus makes the auction site part of the permitted prospectus. In contrast, a hyperlink from a separately accessible auction site to the electronic prospectus would merely cause the documents to be delivered together. Without additional steps to make it clear that the auction screens are part of the prospectus, the auction screens would not be part of the electronic prospectus. Making the auction screens available separate from the electronic prospectus and simply hyperlinking to the prospectus, therefore, will not alleviate the concern that the auction screens are non-conforming prospectuses, the use of which violates Section 5(b)(1).

The method described, where the underwriter makes the auction site accessible through the electronic prospectus, is not the exclusive method to make a document part of the electronic prospectus. For example, the electronic prospectus could be represented by means of its table of contents, with each item in the table presented as an active hyperlink to the section of the prospectus that the item represents. If the auction site is presented as an item in the table of contents, the hyperlink to the auction site from the table of contents generally would make the auction site a part of the prospectus. Similarly, we believe that the electronic auction could be presented on a web page next to the electronic prospectus along with a statement that the auction web page is part of the prospectus. Our central concerns are that the information be presented in a manner that makes it clear that the information is part of the electronic prospectus and that makes the remainder of the prospectus disclosure easily accessible to investors. We invite issuers and underwriters to consult with us about other means of making an electronic presentation part of the electronic prospectus.

d. Description of the auction in the preliminary prospectus

Any prospectus used by the issuer or the underwriter must meet the requirements of Section 10. For example, the plan of distribution disclosure must describe the auction process in a manner sufficient to satisfy Item 508 of Regulation S-K. The preliminary prospectus should include

a description of the terms to be established by the auction, such as price, a summary of the auction process, and a fair and accurate description, or screen shots, of the Internet web pages that investors participating in the auction will see prior to the auction.

The issuer and the underwriter must evaluate whether they need to update the preliminary prospectus. Whether the prospectus may be updated through a prospectus supplement or through a post-effective amendment will depend upon the circumstances. For example, if the securities are offered and sold pursuant to an effective shelf registration statement and the base prospectus does not describe the auction process, the issuer would file a post-effective amendment to amend the plan of distribution section to satisfy the requirements of Item 508.

e. Filing the auction screens as part of the final prospectus

After the auction, the issuer must file a final prospectus that includes the results of the auction and that provides a fair and accurate representation of the electronic auction presentation. Rule 424(b) requires an issuer to file with the Commission every prospectus with substantive changes from a previously filed prospectus. The auction screens are continually changing during the auction, and every different view of the auction screens is a separate prospectus. Nevertheless, we do not believe it is necessary to file separate prospectuses under Rule 424 for each change to the screens shown during the auction. Instead, the issuer can file a final prospectus that contains a fair and accurate representation of the auction process, including all substantive changes that occurred during the course of the auction.

The final prospectus should, at a minimum, describe the final terms of the offering, interim auction bidding activity, and any other substantive change from information already filed with the Commission. Auction screens, or summaries of the auction screens, at sufficiently small intervals to capture all substantive changes in the bidding process should be filed.

    7. Coordination with Other Government Agencies

On occasion, the staff communicates with other government agencies when disclosure indicates that the rules and regulations enforced by that government entity may materially effect the issuer's operations. For example, the staff continues to have an informal understanding with the staff of the Environmental Protection Agency (" EPA") whereby the Commission staff receives from the EPA lists of companies identified as potentially responsible parties on hazardous waste sites; companies subject to cleanup requirements under Resource Conservation and Recovery Act; and companies named in criminal and civil proceedings under environmental laws. The staff uses this information in its review process.

    8. Monitor of Form 12b-25 Notices

The staff has implemented procedures to strengthen its monitoring efforts of all Forms 12b-25 notices of late filing. Notices are being monitored, with appropriate action taken depending upon the issuer's reason for delay and whether the subject filing is subsequently filed during the extension period. Possible staff action includes referral to the Division of Enforcement and prioritization of the subject report for staff review.

    9. Related Public and Private Offerings

Some companies with pending registration statements have advised the staff that they intend to withdraw the registration statement and shortly thereafter complete the offering without registration in reliance upon the Section 4(2) private offering exemption. This appears to be proposed for both timing and disclosure reasons. In the staff's view, this procedure ordinarily would not be consistent with Section 5 of the Securities Act. The filing of a registration statement for a specific securities offering (as contrasted with a generic shelf registration) constitutes a general solicitation for that securities offering, thus rendering Section 4(2) unavailable for the same offering. In addition, the procedure raises significant integration issues under the traditional five factor test (Securities Act Release No. 4552 (November 6, 1962)) and the staff's integration policy positions, because the subsequent private offering does not appear to be a separate offering.

A related issue arises when a company files a registration statement to register issuances of securities to purchasers who committed to purchase securities from the issuer before the filing of the registration statement on the condition that the securities be registered before issuance. It appears that the purpose of this procedure is to provide the purchasers with registered (rather than restricted) securities. The staff does not believe that this procedure is consistent with the registration provisions of the Securities Act, which cover offers and sales of securities, not issuances. In this situation, it appears that the offers were made and the commitments obtained before filing in reliance upon the Section 4(2) private placement exemption. If so, the registration statement should cover resales by the purchasers, not issuances to the purchasers.

The use of "lock-up agreements" in business combination transactions is common. What is not common or consistent is the extent to which these agreements may be used to lock up target shareholders beyond key executives and "blocking" shareholders of the target. While the signing of a lock-up agreement may constitute the making of an investment decision, the staff, noting the realities of these transactions, traditionally has not raised issues with respect to these agreements in connection with acquisitions of public companies. However, the staff has raised issues concerning recently filed acquisition registration statements where 100% of the target shares are locked up or the "lock-up" group is expanded to include non-traditional "members" such as middle management. [Note that the Commission has proposed to address lock-up agreements and related public and private offerings in Securities Act Release No. 7606A (November 13, 1998).]

    10. Equity Swap Arrangements

Equity swap arrangements (including the related equity security) and similar devices typically shift some or all of the economic interests and risks of an equity security. These arrangements raise a number of legal and regulatory issues under the federal securities laws. Application of Exchange Act Section 16 to these arrangements is addressed in Exchange Act Releases No. 34514 and 37260. Those releases stated that equity swaps and similar transactions are subject to Section 16, and discussed the manner in which they should be reported. The staff continues to consider the issues raised by equity swaps and other risk-shifting transactions in other areas, including disclosure of security holdings and executive compensation, Schedule 13D reporting and transactions subject to Rule 144, Rule 144A and Regulation S. See also Goldman Sachs (December 20, 1999), located in Section X. F. of this outline. The treatment of these transactions under Rule 144 is addressed in Securities Act Release No. 7391 (February 20, 1997). The treatment of these transactions under Regulation S is addressed in Securities Act Release Nos. 7392 and 7505; see Section V. B.

    11. "Gypsy Swaps"

A private purchaser wishes to invest directly in an issuer but hopes to acquire unrestricted securities. Through arrangements and understandings with the issuer, a stockholder with shares that are either restricted securities currently eligible for sale under Rule 144 or unrestricted securities sells the shares to the private purchaser. At about the same time, the issuer sells an equivalent number of shares to the stockholder. The Division's view is that the shares taken by the private purchaser from the stockholder will be restricted securities within the meaning of Rule 144(a)(3). The holding period will date to the private acquisition. A public resale of the shares acquired from the stockholder without regard to the conditions of Rule 144 would raise serious issues under Section 5 of the Securities Act for all parties to the transactions.

    12. Non-Qualified Deferred Compensation Plans

A typical non-qualified deferred compensation plan permits an employee to defer compensation over a set dollar amount. The employer retains those monies. The employee will then either receive a fixed rate of return on the deferred monies or the employer may permit the employee to index the return on those monies off of a number of investment return alternatives.

In a number of no-action positions, the Division has indicated that it would not recommend enforcement action if transactions in non-qualified deferred compensation plans were not registered. The requests in those instances set forth two bases for the determination that registration under the Securities Act was not required. First, those requests set forth the argument that the offer and sale of interests in the deferred compensation plan did not involve the offer or sale of a security because the decision to participate in those plans was based primarily on tax management, not investment, purposes. Second, the requests contained the argument that the employees participating in the plan were top-level executives who did not need the protections provided by registration under the Securities Act. In providing the no-action position requested, the Division's responses state that, while not agreeing with the analysis in the request, it would not recommend enforcement action if transactions under the plans were not registered. The Division has not taken such a no-action position since 1991.

Due to a number of market and regulatory factors, non-qualified deferred compensation plans have greatly proliferated, both with respect to the number of employers offering such plans and the number of employees participating. At this time, the Division is not prepared to disregard the argument that the debt owing to plan participants is analogous to investment notes, which typically are viewed as debt securities. Further, the staff is not persuaded that there is a meaningful distinction between those plans that offer returns tied to different investment alternatives and those that offer only a fixed rate. The Division, therefore, will not grant requests for no-action with respect to any non-qualified deferred compensation plan, including those that have an interest only return. The Division has not stated affirmatively, however, that all interest only deferred compensation plans involve securities. Instead, the Division currently is leaving that question for counsel's analysis of the facts and circumstances. To the extent that interests in a non-qualified deferred compensation plan are securities, registration would be required unless the offerings under the plan would qualify for an exemption, e. g., Section 4(2).

Form S-8 would be available when an employer registers the offer and sale of interests in the deferred compensation plan under the Securities Act. The filing fee should be based on the amount of compensation being deferred, not on the ultimate investment return. As the "deferred compensation obligations" to be registered are obligations of the issuer/ employer, not interests in the plan, the registration of the "deferred compensation obligations" would not result in a requirement that a deferred compensation plan file a Form 11-K with respect to those securities. Further, based on the unique terms of the "deferred compensation obligations" (both with respect to interest and maturity), compliance with the Trust Indenture Act of 1939 has not been required.

13. Trust Indenture Act Issues Arising in
Certain Transactions Exempt from Securities Act Registration

Offerings exempt from registration under Sections 3(a)(9) and 3(a)(10) of the Securities Act and Section 1145(a) of the Bankruptcy Code are not exempt from qualification under the Trust Indenture Act. Like Section 5 of the Securities Act, Section 306 of the Trust Indenture Act works transactionally. Unless the indenture for a debt security is qualified under Section 305 of the Trust Indenture Act, which covers registered offerings, or exempt from qualification under Section 304, the sale of the debt security violates Section 306 of the statute. Section 306(c) forbids any offer of the debt security until an application for qualification of the related indenture has been filed with the Commission.

The Division has recently noted a number of offerings of debt securities for issuers in Chapter 11 proceedings where the applications for qualification on Form T-3 were not filed until after approval of the plans of reorganization by both creditors and other claimants and the bankruptcy courts. The Division's view is that the offering event in bankruptcy is the solicitation of plan approval from creditors and other claimants. Accordingly, the application for qualification in these cases should be filed before such approval is sought.

    14. Legality Opinion Issues

It is customary practice for counsel drafting legality opinions regarding securities whose issuer is incorporated in Delaware to limit their opinion to "the Delaware General Corporation Law." In these situations, we ask that counsel revise its opinion to make clear that the law covered by the opinion includes not only the Delaware General Corporation Law, but also the applicable provisions of the Delaware Constitution and reported judicial decisions interpreting these laws.

Recently, we discussed this limitation with the Ad Hoc Committee on Legal Opinions in SEC Filings of the Federal Regulation of Securities Committee of the Business Law Section of the American Bar Association. In those discussion, the Ad Hoc Committee emphasized that the reference to the "Delaware General Corporations Law" was an opinion drafting convention and that the practicing bar understood this phrase to mean the Delaware General Corporation Law, the applicable provisions of the Delaware Constitution, and reported judicial decisions interpreting these laws.

Based on these discussions, we have revised our procedures for reviewing a legality opinion filed as an exhibit to a registration that includes a statement that it is "limited to the Delaware General Corporation Law." Our new procedures are as follows:

We will issue a comment asking counsel to confirm to us in writing that it concurs with our understanding that the reference and limitation to "Delaware General Corporate Law" includes the statutory provisions and also all applicable provisions of the Delaware Constitution and reported judicial decisions interpreting these laws. As part of this standard comment, we will ask that counsel file this written confirmation as correspondence on the EDGAR system. As such, it will be part of the Commission's official file regarding the related registration statement.

Once we receive this written confirmation from counsel, we will not comment further on the inclusion of this language in the opinion for that registration statement.

    15. Plain English Initiative

On January 22, 1998, the Commission adopted the final plain English rules (Securities Act Release No. 7497). See also the proposed rules at Securities Act Release No. 7380 (January 14, 1997). These rules apply to public companies and mutual funds. The Division of Corporation Finance has also issued Staff Legal Bulletin No. 7 on the new rules, and updated it on June 7, 1999.

"A Plain English Handbook--How to Create Clear SEC Disclosure Documents," issued by the Office of Investor Education and Assistance, is available. You can download a copy from our web site at http:// www. sec. gov or request a paper copy by calling 1-800-SEC-0330.

    16. Clarification of Oil and Gas Reserve Definitions and Requirements

Over the last several years, the estimation and classification of petroleum reserves has been impacted by the development of new technologies such as 3-D seismic interpretation and reservoir simulation. Computer processor improvements have allowed the increased use of probabilistic methods in proved reserve assessments. These have led to issues of consistency and, therefore, some confusion in the reporting of proved oil and gas reserves by public issuers in their filings with the Commission. The following discussion addresses some issues the Division of Corporation Finance's engineering staff has detected in its review of these filings.

The definitions for proved oil and gas reserves for the SEC are found in Rule 4-10(a) of Regulation S-X of the Securities Exchange Act of 1934. The SEC definitions are below in bold italics. Under each section we have tried to explain the SEC staff's position regarding some of the more common issues that arise from each portion of the definitions. As most engineers who deal with the classification of reserves have come to realize, it is difficult, if not impossible, to write reserve definitions that easily cover all possible situations. Each case has to be studied as to its own unique issues. This is true with the Society of Petroleum Engineers' and others' reserve definitions as well as the SEC's definitions.

a. Proved oil and gas reserves are the estimated quantities of crude oil, natural gas, and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions, i. e., prices and costs as of the date the estimate is made. Prices include consideration of changes in existing prices provided by contractual arrangements, but not on escalations based upon future conditions.

The determination of reasonable certainty is generated by supporting geological and engineering data. There must be data available which indicate that assumptions such as decline rates, recovery factors, reservoir limits, recovery mechanisms and volumetric estimates, gas-oil ratios or liquid yield are valid. If the area in question is new to exploration and there is little supporting data for decline rates, recovery factors, reservoir drive mechanisms etc., a conservative approach is appropriate until there is enough supporting data to justify the use of more liberal parameters for the estimation of proved reserves. The concept of reasonable certainty implies that, as more technical data becomes available, a positive, or upward, revision is much more likely than a negative, or downward, revision.

Existing economic and operating conditions are the product prices, operating costs, production methods, recovery techniques, transportation and marketing arrangements, ownership and/ or entitlement terms and regulatory requirements that are extant on the effective date of the estimate. An anticipated change in conditions must have reasonable certainty of occurrence; the corresponding investment and operating expense to make that change must be included in the economic feasibility at the appropriate time. These conditions include estimated net abandonment costs to be incurred and duration of current licenses and permits.

If oil and gas prices are so low that production is actually shut-in because of uneconomic conditions, the reserves attributed to the shut-in properties can no longer be classified as proved and must be subtracted from the proved reserve data base as a negative revision. Those volumes may be included as positive revisions to a subsequent year's proved reserves only upon their return to economic status.

b. Reservoirs are considered proved if economic producibility is supported by either actual production or conclusive formation test. The area of a reservoir considered proved includes that portion delineated by drilling and defined by gas-oil and/ or oil-water contacts, if any, and the immediately adjoining portions not yet drilled, but which can be reasonably judged as economically productive on the basis of available geological and engineering data. In the absence of information on fluid contacts, the lowest known structural occurrence of hydrocarbons controls the lower proved limits of the reservoir.

Proved reserves may be attributed to a prospective zone if a conclusive formation test has been performed or if there is production from the zone at economic rates. It is clear to the SEC staff that wireline recovery of small volumes (e. g. 100 cc) or production of a few hundred barrels per day in remote locations is not necessarily conclusive. Analyses of open-hole well logs which imply that an interval is productive are not sufficient for attribution of proved reserves. If there is an indication of economic producibility by either formation test or production, the reserves in the legal and technically justified drainage area around the well projected down to a known fluid contact or the lowest known hydrocarbons, or LKH may be considered to be proved.

In order to attribute proved reserves to legal locations adjacent to such a well (i. e. offsets), there must be conclusive, unambiguous technical data which supports reasonable certainty of production of those volumes and sufficient legal acreage to economically justify the development without going below the shallower of the fluid contact or the LKH. In the absence of a fluid contact, no offsetting reservoir volume below the LKH from a well penetration shall be classified as proved.

Upon obtaining performance history sufficient to reasonably conclude that more reserves will be recovered than those estimated volumetrically down to LKH, positive reserve revisions should be made.

c. Reserves that can be produced economically through applications of improved recovery techniques (such as fluid injection) are included in the "proved" classification when successful testing by a pilot project, or the operation of an installed program in the reservoir, provides support for the engineering analysis on which the project or program was based.

If an improved recovery technique which has not been verified by routine commercial use in the area is to be applied, the hydrocarbon volumes estimated to be recoverable cannot be classified as proved reserves unless the technique has been demonstrated to be technically and economically successful by a pilot project or installed program in that specific rock volume. That demonstration should validate the feasibility study leading to the project.

d. Estimates of proved reserves do not include the following:

oil that may become available from known reservoirs but is classified separately as "indicated additional reserves";

crude oil, natural gas, and natural gas liquids, the recovery of which is subject to reasonable doubt because of uncertainty as to geology, reservoir characteristics, or economic factors; crude oil, natural gas, and natural gas liquids, that may occur in undrilled prospects; crude oil, natural gas, and natural gas liquids, that may be recovered from oil shales, coal, gilsonite and other sources.

Geologic and reservoir characteristic uncertainties such as those relating to permeability, reservoir continuity, sealing nature of faults, structure and other unknown characteristics may prevent reserves from being classified as proved. Economic uncertainties such as the lack of a market (e. g. stranded hydrocarbons), uneconomic prices and marginal reserves that do not show a positive cash flow can also prevent reserves from being classified as proved. Hydrocarbons "manufactured" through extensive treatment of gilsonite, coal and oil shales are mining activities reportable under Industry Guide 7. They cannot be called proved oil and gas reserves. However, coal bed methane gas can be classified as proved reserves if their recovery is shown to be economically feasible.

In developing frontier areas, the existence of wells with a formation test or limited production may not be enough to classify those estimated hydrocarbon volumes as proved reserves. Issuers must demonstrate that there is reasonable certainty that a market exists for the hydrocarbons and that an economic method of extracting, treating and transporting them to market exists or is feasible and is likely to exist in the near future. A commitment by the company to develop the necessary production, treatment and transportation infrastructure is essential to the attribution of proved undeveloped reserves. Significant lack of progress on the development of those reserves may be evidence of a lack of such a commitment. Affirmation of this commitment may take the form of signed sales contracts for the products; request for proposals to build facilities; signed acceptance of bid proposals; memos of understanding between the appropriate organizations and governments; firm plans and timetables established; approved authorization for expenditures to build facilities; approved loan documents to finance the required infrastructure; initiation of construction of facilities; approved environmental permits etc. Reasonable certainty of procurement of project financing by the company is a requirement for the attribution of proved reserves. An inordinately long delay in the schedule of development may introduce doubt sufficient to preclude the attribution of proved reserves.

The history of issuance and continued recognition of permits, concessions and commerciality agreements by regulatory bodies and governments should be considered when determining whether hydrocarbon accumulations can be classified as proved reserves. Automatic renewal of those agreements cannot be expected if the regulatory body has the authority to end the agreement unless there is a long and clear track record which supports the conclusion that those approvals and renewal are a matter of course. 6

e. Proved developed oil and gas reserves are reserves that can be expected to be recovered through existing wells with existing equipment and operating methods. Additional oil and gas expected to be obtained through the application of fluid injection or other improved recovery techniques for supplementing the natural forces and mechanisms of primary recovery should be included as "proved developed reserves" only after testing by a pilot project or after the operation of an installed program has confirmed through production response that increased recovery will be achieved.

Currently producing wells and wells awaiting minor sales connection expenditure, recompletion, additional perforations or bore hole stimulation treatment would be examples of properties with proved developed reserves since the majority of the expenditures to develop the reserves has already been spent.

Proved developed reserves from improved recovery techniques can be assigned after either the operation of an installed pilot program shows a positive production response to the technique or the project is fully installed and operational and has shown the production response anticipated by earlier feasibility studies. In the case with a pilot, proved developed reserves can be assigned only to that volume attributable to the pilot's influence. In the case of the fully installed project, response must be seen from the full project before all the proved developed reserves estimated can be assigned. If a project is not following original forecasts, proved developed reserves can only be assigned to the extent actually supported by the current performance. An important point here is that attribution of incremental proved developed reserves from the application of improved recovery techniques requires the installation of facilities and a production increase.

f. Proved undeveloped oil and gas reserves are reserves that are expected to be recovered from new wells on undrilled acreage, or from existing wells where a relatively major expenditure is required for recompletion. Reserves on undrilled acreage shall be limited to those drilling units offsetting productive units that are reasonably certain of production when drilled. Proved reserves for other undrilled units can be claimed only where it can be demonstrated with certainty that there is continuity of production from the existing productive formation. Under no circumstances should estimates of proved undeveloped reserves be attributable to any acreage for which an application of fluid injection or other improved recovery technique is contemplated, unless those techniques have been proved effective by actual tests in the area and in the same reservoir. (Emphasis added)

The SEC staff points out that this definition contains no mitigating modifier for the word certainty. Also, continuity of production requires more than the technical indication of favorable structure alone (e. g. seismic data) to meet the test for proved undeveloped reserves. Generally, proved undeveloped reserves can be claimed only for legal and technically justified drainage areas offsetting an existing productive well (but structurally no lower than LKH). If there are at least two wells in the same reservoir which are separated by more than one legal location and which show communication (reservoir continuity), proved undeveloped reserves could be claimed between the two wells, even though the location in question might be more than an offset well location away from any of the wells. In this illustration, seismic data could be used to help support this claim by showing reservoir continuity between the wells, but the required data would be the conclusive evidence of communication from production or pressure tests. The SEC staff emphasizes that proved reserves cannot be claimed more than one offset location away from a productive well if there are no other wells in the reservoir, even though seismic data may exist. The use of high-quality, well calibrated seismic data can improve reservoir description for performing volumetrics (e. g. fluid contacts). However, seismic data is not an indicator of continuity of production and, therefore, can not be the sole indicator of additional proved reserves beyond the legal and technically justified drainage areas of wells that were drilled. Continuity of production would have to be demonstrated by something other than seismic data.

In a new reservoir with only a few wells, reservoir simulation or application of generalized hydrocarbon recovery correlations would not be considered a reliable method to show increased proved undeveloped reserves. With only a few wells as data points from which to build a geologic model and little performance history to validate the results with an acceptable history match, the results of a simulation or material balance model would be speculative in nature. The results of such a simulation or material balance model would not be considered to be reasonably certain to occur in the field to the extent that additional proved undeveloped reserves could be recognized. The application of recovery correlations which are not specific to the field under consideration is not reliable enough to be the sole source for proved reserve calculations.

Reserves cannot be classified as proved undeveloped reserves based on improved recovery techniques until they have been proved effective in that reservoir or an analogous reservoir in the same geologic formation in the immediate area. An analogous reservoir is one having at least the same values or better for porosity, permeability, permeability distribution, thickness, continuity and hydrocarbon saturations.

g. Topic 12 of Accounting Series Release No. 257 of the Staff Accounting Bulletins states:

In certain instances, proved reserves may be assigned to reservoirs on the basis of a combination of electrical and other type logs and core analyses which indicate the reservoirs are analogous to similar reservoirs in the same field which are producing or have demonstrated the ability to produce on a formation test.

If the combination of data from open-hole logs and core analyses is overwhelmingly in support of economic producibility and the indicated reservoir properties are analogous to similar reservoirs in the same field which have produced or demonstrated the ability to produce on a conclusive formation test, the reserves may be classified as proved. This would probably be a rare event especially in an exploratory situation. The essence of the SEC definition is that in most cases there must at least be a conclusive formation test in a new reservoir before any reserves can be considered to be proved.

h. Statement of Financial Accounting Standards 69, paragraph 30. a. requires the following disclosure:

Future cash inflows. These shall be computed by applying year-end prices of oil and gas relating to the enterprise's proved reserves to the year-end quantities of those reserves. (Emphasis added)

This requires the use of physical pricing determined by the market on the last day of the (fiscal) year. For instance, a west Texas oil producer should determine the posted price of crude (hub spot price for gas) on the last day of the year, apply historical adjustments (transportation, gravity, BS& W, purchaser bonuses, etc.) and use this oil or gas price on an individual property basis for proved reserve estimation and future cash flow calculation (this price is also used in the application of the full cost ceiling test). A monthly average is not the price on the last day of the year, even though that may be the price received for production on the last day of the year.

Paragraph 30b) states that future production costs are to be based on year-end figures with the assumption of the continuation of existing economic conditions.

i. Position on Probabilistic Methods of Reserve Estimating

Probabilistic methods of reserve estimating have become more useful due to improved computing and more important because of its acceptance by professional organizations such as the SPE. The SEC staff feels that it would be premature to issue any confidence criteria at this time. The SPE has specified a 90% confidence level for the determination of proved reserves by probabilistic methods. Yet, many instances of past and current practice in deterministic methodology utilize a median or best estimate for proved reserves. Since the likelihood of a subsequent increase or positive revision to proved reserve estimates should be much greater than the likelihood of a decrease, we see an inconsistency that should be resolved. If probabilistic methods are used, the limiting criteria in the SEC definitions, such as LKH, are still in effect and shall be honored. Probabilistic aggregation of proved reserves can result in larger reserve estimates (due to the decrease in uncertainty of recovery) than simple addition would yield. We require a straight forward reconciliation of this for financial reporting purposes.

j. Use of Cautionary Note in Connection with Disclosure Language

We have seen in press releases and web sites disclosure language by oil and gas companies which would not be allowed in a document filed with the SEC. We will request that these disclosures be accompanied by the following cautionary language:

Cautionary Note to U. S. Investors --The United States Securities and Exchange Commission permits oil and gas companies, in their filings with the SEC, to disclose only proved reserves that a company has demonstrated by actual production or conclusive formation tests to be economically and legally producible under existing economic and operating conditions. We use certain terms {in this press release/ on this web site}, such as [identify the terms], that the SEC's guidelines strictly prohibit us from including in filings with the SEC. U. S. Investors are urged to consider closely the disclosure in our Form XX, File No. X-XXXX, available from us at [registrant address at which investors can request the filing]. You can also obtain this form from the SEC by calling 1-800-SEC-0330.

Examples of these disclosures would be statements regarding "probable," "possible," or "recoverable" reserves among others.

k. Consent of Experts and Potential Civil Liability

The SEC staff reminds professionals engaged in the practice of reserve estimating and evaluation that the Securities Act of 1933 subjects to potential civil liability every expert who, with his or her consent, has been named as having prepared or certified any part of the registration statement, or as having prepared or certified any report or valuation used in connection with the registration statement. These experts include accountants, attorneys, engineers or appraisers.

    17. Shelf Registration Deal Information under Rule 412

On several occasions, Form 8-K was used to file information identified as relating to a particular takedown of securities from a delayed shelf registration statement. By operation of the shelf registration system, the Form 8-K was incorporated by reference into the prospectus of the relevant effective S-3 registration statement. The Form 8-K included information that, if not made a part of the Section 10(b) prospectus, may have violated Section 5(b)(1) if used in the offering as contemplated.

In each case, following the closing of the transaction, the registrant filed another Form 8-K for the sole purpose of asserting that the information contained in the earlier Form 8-K and incorporated by reference into the registration statement was expunged. In these cases, we were advised by the registrants that they relied on Securities Act Rule 412 for this removal of information. Under Rule 412, statements in documents incorporated by reference in a Securities Act registration statement are deemed to be modified or superseded by new information contained in a prospectus or a document later incorporated by reference.

While the staff generally has no objection to the use of Form 8-K to include information in a prospectus that is part of a delayed shelf registration statement, Rule 412 does not permit an issuer to file a statement later to remove or "expunge" the information in the earlier Form 8-K. Registrants are advised to refrain from attempting to do so. The staff is of the view that any attempt to remove information under Rule 412 would be null and void. If this practice comes to the attention of the staff in the future, the registrant will be asked to file an amended Form 8-K to correct the attempted removal. Registrants are also advised that they may include deal-specific information as part of the prospectus in a shelf registration statement by filing that information under Securities Act Rule 424 before its use as part of the Section 10(b) prospectus.

    18. Recent Enforcement Action CGI Capital, Inc.

On September 29, 2000, CGI Capital, Inc. consented to the entry of an Order by the Commission censuring CGI Capital for its conduct in connection with two unregistered offerings and directing CGI Capital to cease and desist from committing or causing violations of Section 5 of the Securities Act. CGI Capital also agreed to pay a $25,000 civil penalty.

From August 1999 through December 1999, CGI Capital, a broker-dealer registered with the Commission, solicited thousands of individuals to invest in two unregistered offerings available through its web site. Specifically, CGI Capital disseminated e-mail messages to prospective investors that contained:

preliminary information regarding the offerings;

a link to CGI Capital's web site; and

a password that allowed these investors to access a password-protected area of CGI Capital's web site that contained brief sales presentations and subscription forms for each offering.

Some recipients of the e-mails did not have a pre-existing substantive relationship with CGI Capital, and CGI Capital failed to determine adequately whether the prospective investors were either accredited or sophisticated. The Commission found that these e-mails constituted general solicitation, and therefore, there was no exemption available for the unregistered offerings.

The Commission also found that CGI Capital engaged in a general solicitation by failing to take adequate steps to restrict access to the offerings on its web site. [Cf. No-Action Letter of Divisions of Corporation Finance and Market Regulation to IPONET (July 26, 1996); Interpretive Release on Use of Electronic Media, Securities Act Rel. No. 33-7856 (April 28, 2000). ] In particular, CGI Capital:

sent its e-mail solicitations to several thousand potential investors and included in each e-mail a password to the password-protected page of its web site containing the offering materials;

allowed these potential investors to access the offering materials on its web site before CGI Capital had made a determination that any particular potential investor was accredited or sophisticated;

failed to gather information from certain potential investors in order to form a reasonable basis for believing these investors to be accredited or sophisticated; and

allowed these potential investors to purchase securities in offerings that had been posted on the password-protected page of its web site before CGI Capital had made a determination that these potential investors were accredited or sophisticated.

As a result, the Commission found that CGI's activities violated Section 5 of the Securities Act.

    B. Industry-Specific Issues

        1. Real Estate

            a. Review of Filings

The Division has issued three releases regarding real estate disclosure. On June 17, 1991, the Commission issued an interpretive release relating to partnership offerings and reorganizations (Securities Act Release No. 6900); on October 30, 1991, final rules concerning disclosure of roll-up transactions were issued (Securities Act Release No. 6922). On December 1, 1994, the Commission adopted amendments to its roll-up rules (Securities Act Release No. 7113). The staff considers the disclosure guidelines of each of these releases in connection with its reviews of registration statements and proxy statements filed by limited partnerships and real estate investment trusts.

Current real estate filings relate primarily to real estate investment trusts (REITs) and, to a lesser extent, limited partnerships and limited liability companies. Frequently, REIT filings contain an UPREIT structure which includes an Umbrella Operating Partnership formed by the sponsor and affiliated partnerships to contribute properties or partnership interests to the REIT. In connection with REIT initial public offerings, the staff considers the availability of any claimed exemption from Securities Act registration for the pre-formation roll-up transactions undertaken to form the operating partnership.

Primary offerings by Operating Partnerships must comply with appropriate form requirements. Operating Partnerships may use Form S-3 if the applicable requirements are met, specifically, Instruction I. C., but since the Operating Partnership is unlikely to be able to meet the requirements of Staff Accounting Bulletin 53, separate financial statements and related disclosure must be provided either in the registration statement or through incorporation by reference of a voluntary Form 10. Following the offering, applicable reports must be filed by the Operating Partnership.

Reviews of limited partnership offerings and proxy solicitation materials continue to focus on prior performance and on claims made by sponsors concerning investment obligations and future performance. These reviews also focus on changes to partnership objectives and structure. Finally, the staff continues to examine the practices and disclosure associated with the solicitation of proxies and registration statements related to roll-ups, pursuant to the revised rules. See also Section II. C. 1 for a discussion of the disclosure required in tender offers for limited partnership units.

b. Sales Literature Used in Connection with the Offering of Limited Partnerships

Item 19 of Industry Guide 5 requires that sales literature used in the offering of limited partnership units, including material marked for "Broker Dealer Use Only," be submitted for staff review. These materials should provide a balanced presentation of the risks and rewards involved in the offering. All information must be consistent with the information and representations contained in the prospectus and the sales literature should not be presented in a manner which obscures the prospectus cover page. Registrants should contact the staff before using submitted sales materials.

c. Low Income Housing, Rehabilitation, and Historic Tax Credit Real Estate Limited Partnerships

Certain real estate limited partnership offerings indicate the sponsor's intention to invest in low income housing or other programs eligible for federal or state income tax credits. Most of these offerings highlight the percentage returns to the investor of the tax credits on a simple annualized basis. Since the tax credits are available for only 10 years and the enabling statutes require a 15-year holding period for the property, the rate of return disclosure should include the effects of the time value of money. Further, since it is possible that the property may have no or little residual value at the end of the 15-year holding period, the disclosure of the rate of return should assume a zero resale value of the property.

Further, prior performance disclosure of the results of earlier tax credit offerings by the sponsor should be included. Disclosure of the total amount of tax credits generated for each year should be included as should the amount of tax credits per $1000 invested.

2. Exemption from Registration for
Bank and Thrift Holding Company Formations

Section 3(a)(12) of the Securities Act provides an exemption from registration for securities issued in connection with the formation of a bank or savings association holding company where shareholders maintain the same proportional interest in the holding company as they had in the bank or savings association; the rights and interests of the shareholders are substantially the same after the transaction as before it; and the holding company has substantially the same assets and liabilities, on a consolidated basis, as the bank or savings association had before the transaction. The staff has informally taken the position that the exemption would not be available if the new holding company's corporate charter contained antitakeover provisions that were not in the governing documents of the predecessor bank or thrift.

    3. Structured Financings

In fall 1992, the Commission extended the benefits of Rule 415 "shelf" registration through the expansion of the availability of Form S-3 to investment grade asset-backed securities offerings (Securities Act Release No. 6964 (October 22, 1992)(the "Shelf Release")). Shortly thereafter, the Commission adopted Rule 3a-7 under the Investment Company Act of 1940 excluding from the definition of "investment company" structured financings that meet the rule's conditions (Investment Company Act Release No. 19105 (November 19, 1992)). These changes appear to have precipitated, or at least coincided with, a movement in the structured finance market toward securitization of assets in the public markets that previously were offered in the private markets. Significant disclosure and eligibility issues continue to come up as a result of market developments.

a. Asset Concentration

The Shelf Release expressly does not adopt a specific asset concentration test. Instead, asset concentration questions have been addressed through existing disclosure rules. While an asset concentration test was not included, the release indicates that the definition of asset-backed security does not encompass securities issued in structured financings for one obligor or group of related obligors.

    i. Multiple Core Prospectuses

Another issue involving asset concentration arises in the context of pooling several different types of underlying assets. The staff permits issuers to register on a single shelf registration statement asset-backed securities supported by more than one category of underlying assets without specifying the amount of each type to be offered. The registration statement must specifically identify the various asset categories and include a separate core prospectus for each such category. In considering whether a separate core prospectus is required, the staff will consider whether the assets described are intended to be pooled together or securitized separately. If the latter, separate core prospectuses ordinarily would be required.

    ii. Commercial Mortgages

For securitization of commercial mortgages and leases, where the mortgage loan is a non-recourse obligation of the mortgagor, disclosure related to the operating property(ies) will be required where concentration exists. The staff applies the standards described in Staff Accounting Bulletin 71/ 71A (" SAB 71/ 71A"). SAB 71/ 71A generally employs a 20% asset concentration test to determine whether audited property financial statements are required. At concentration levels between 10-20%, financial and other information regarding the underlying properties is required. In determining whether these concentration thresholds are crossed, loans to the same obligor, group of related obligors, or loans on related properties may be aggregated.

In addition, where a mortgage loan or loans of a single obligor, or group of related obligors, accounts for more than 45% of the pool assets, one or more co-issuers may exist. See FBC Conduit Trust I, First Boston Mortgage Securities Corporation (October 6, 1987).

b. Securitizing Outstanding Securities

    i. Corporate Debt Securities

The pooling and securitization of outstanding corporate debt securities of other issuers may be registered on Form S-3 if the requirements of the Form for asset-backed securities offerings are met, provided that the depositor would be free to publicly resell the securities without registration. Thus, a depositor generally cannot include restricted securities (i. e., privately-placed securities where the Rule 144(k) two-year holding period has not run) nor can it include registered securities if the securitization is part of the original distribution. To provide certainty in deciding what is part of the original distribution in resecuritizations by affiliates of underwriters involved in the original offering, the staff has used a bright line test (i. e., securities purchased in the secondary market and at least three months after the depositor had sold out any unsold allotment are not viewed as part of the original dispatch).

Where 20% or more of the pool consists of the securities of a single issuer, the staff requires audited financial statements of such issuer to be included in the prospectus. However, if the underlying issuer is eligible to use Form S-3 for a primary common stock offering, and the depositor's transaction in the securities is purely secondary (e. g., there is no tie to the issuer or the issuer's distribution), the staff would accept a reference in the prospectus to the issuer's periodic reports on file with the Commission. Of course, the prospectus must include a description of the material terms of the pooled securities.

In connection with Exchange Act reporting, reference to the S-3 eligible underlying issuer's periodic reports on file with the Commission will be accepted in lieu of direct disclosure of this information. In addition, the staff generally requires the depositor to undertake to provide financial and other information relating to such underlying issuer directly in its reports in the event such underlying issuer terminates reporting after the pooling transaction.

    ii. Asset-Backed Securities

Securitization of outstanding asset-backed securities is treated similarly if the underlying trust has outstanding securities held by non-affiliates in excess of $75 million and files periodic reports with the Commission. The securities of government-sponsored enterprises (" GSE") which have a comparable market float and which make information publicly available comparable to that of Exchange Act reporting entities are treated similarly.

    iii. Municipal Securities

The offering of asset-backed securities supported by pools of municipal bonds where asset concentration exists, in general, requires that financial statements and other information relating to the underlying municipal issuer be provided. This information must be included directly in the prospectus, must be current, and must otherwise satisfy fully the disclosure requirements under the federal securities regulations.

While there may be instances where financial statements of the municipal issuer are not material to the investor in the asset-backed security, such instances would appear to be rare and the staff will require appropriate legal opinions and other documentation necessary to support the conclusion that financial and other information relating to the municipal issuer is not material to investors.

c. Structuring the Offering

Often the payment terms of asset-backed securities are tailored to meet the particular investment needs of the investor. Prior to effectiveness of the registration statement, investors often ask the underwriter for various computational materials so as to analyze prepayment and other assumptions affecting yield. These computational materials are not permissible prospectuses under the Securities Act and the Commission's rules and regulations. However, recognizing the realities of the asset-backed market, the staff has issued three no-action letters that recognize the industry's practice of providing written information (other than the statutory prospectus) to prospective purchasers of asset-backed securities when negotiating and structuring the securities to meet purchasers' investment criteria. These letters generally permit the provision of limited information outside the preliminary prospectus to purchasers, provided that the final information is filed as part of the registration statement.

    4. Credit Linked Securities of Bank Subsidiaries

Recently, a number of banks proposed the following transaction structure: the bank forms a limited purpose finance subsidiary; the bank transfers mortgages or asset-backed securities to the subsidiary; the bank owns all of the subsidiary's common stock; and the subsidiary registers the sale of its preferred stock to the public.

The source of funds for dividend payments on the preferred stock would be limited to the income generated by the finance subsidiary's assets. The banks proposed this structure because the preferred securities of the subsidiary may, under relevant risk based capital guidelines, qualify as capital of the bank.

Under bank regulations, if a financial regulatory event occurs, banks must retrieve, or "claw back," the assets of these subsidiaries. Because the assets of these subsidiaries are subject to this claw back, this structure raises significant registration and disclosure issues.

Under one structure, the preferred securities of the subsidiary automatically convert into securities of the bank. Therefore:

the bank and the subsidiary must be co-registrants on the registration statement for the initial sale of the preferred stock since the bank is also offering preferred stock;

the full audited financial statements of the bank must be included in this registration statement; and

if the bank's financial statements are not in US GAAP, they must be reconciled to US GAAP.

If the bank regulators can require the bank to claw back the subsidiary's assets, the financial condition of the bank is material to the subsidiary preferred stockholder at all times. Therefore:

the full audited financial statements of the bank must be in the registration statement and in the subsequent periodic reports of the subsidiary; and

if the bank's financial statements are not in US GAAP, they must be reconciled to US GAAP.