Company Name: NASD Regulation, Inc.
Public Availability Date: Jan. 21, 2000 

[LETTER OF INQUIRY]

November 1, 1999

Richard K. Wulff
Assistant Director
Office of Small Business
Division of Corporation Finance
450 5^th Street, N.W.
Washington, D. C. 20549

Re: Tradeability of Securities Distributed by Means Other than Public Offerings

Dear Mr. Wulff:

The purpose of this letter is to request the guidance of the Division of Corporation Finance ("Division") as to whether certain specific factual scenarios present potential violations of Section 5 of the Securities Act of 1933 ("Securities Act"). The Market Regulation Departments OTC Compliance Unit ("Unit") reviews Form 211 filings submitted by potential market makers to determine whether they are in compliance with SEC 15c2-11 and NASD Rule 6740 before they are cleared to initiate or resume quotation of a non-Nasdaq security in any quotation medium. During the course of these reviews, the staff has been presented with certain factual scenarios that, based on the nature of the initial security distribution of blank check shell company issuers, either the initial distribution or the redistribution of the shares in the aftermarket may constitute violations of Section 5 of the Securities Act. Set forth below are various scenarios that the Unit has encountered, or feels that it may encounter, while reviewing Form 211 filings. The staff requests that the Division provide its opinion on the following scenarios with respect to potential violations of the securities rules:

1. As a gift the issuer transferred a nominal amount of its shares (less than 10% of the total float) to between 20 and 50 individuals under Section 4(2) of the Securities Act. After the gift recipients have held their shares for two years, a broker/dealer submits a Form 211 citing the gifted shares as the only free-trading securities. The application does not disclose whether the recipients are sophisticated investors, although the individual who controls the issuer frequently has gifted shares of other companies to the same individuals on other occasions.

2. The issuer transferred a significant amount of its shares to one individual under Section 4(2) of the Securities Act. Then that individual in turn gifts a nominal amount of the shares to between 20 and 50 individuals. After the gift recipients have held their shares for two years, a broker/dealer submits a Form 211 citing the gifted shares as the only free-trading securities. The application does not disclose whether the recipients are sophisticated investors, although the individual who gifted the shares frequently has gifted shares of other companies to the same individuals on other occasions.

3. The issuer transferred a significant amount of its shares to one individual under Section 4(2) of the Securities Act. That individual holds the shares for two years and then in turn gifts a nominal amount of the shares to between 20 and 50 individuals. After the gift recipients have held their shares a few months, a broker/dealer submits a Form 211 citing the gifted shares as the only free-trading securities. The application does not disclose whether the recipients are sophisticated investors, although the individual who gifted the shares frequently has gifted shares of other companies to the same individuals on other occasions.

4. A small number of shareholders (less than ten) hold all of the free-trading shares. A broker/dealer submits a Form 211 indicating that the concentration of ownership in the hands of so few shareholders will not result in an ongoing distribution because it expects the market for the security to develop slowly.

5. A small number of shareholders (less than ten) control nearly all (more than 90%) of the free trading shares in the issuer. The remaining nominal amount of free-trading shares (less than 10%) are widely dispersed among a larger number of shareholders (50 or more individuals). A broker/dealer submits a Form 211 indicating that the concentration of ownership in the hands of so few shareholders will not result in an ongoing distribution because it expects the market for the security to develop slowly and considers the number of total shareholders to be determinative.

6. An issuer controlled by one individual issued shares to another company controlled by the same individual pursuant to SEC Rule 701. The issuer filed a Form 10 with the SEC that became effective by default. The second company then sells all its shares in the issuer through a brokerage firm. A second broker/dealer submits a Form 211 indicating that the shares sold through the first broker/dealer are all free-trading securities.

7. A reporting shell company merged with a private company and the former controlling shareholder of the reporting shell company sold his shares to numerous individuals more than three months after he ceased to be an affiliate of the post-merger company. A market maker submits a Form 211 citing the post-merger shares sold by the former control person as the only free-trading shares.

Thank you for your attention to this matter. We look forward to receiving the Divisions guidance on whether any of these scenarios are of regulatory concern to the Division. If you have any questions, please do not hesitate to contact me at (301) 978-2097.

Sincerely,

Ken Worm

Assistant Director

OTC Compliance Unit

[STAFF REPLY LETTER]

January 21, 2000

Mr. Ken Worm

Assistant Director

OTC Compliance Unit

NASD Regulation, Inc.

9513 Key West Avenue

Rockville, MD 20850

Re: NASD Regulation, Inc.

Incoming letter dated November 1, 1999

Dear Mr. Worm:

You have raised a question regarding the "free trading" status ¹ of securities initially issued by so-called blank check companies in a number of factual scenarios.

A blank check company is a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person. In 1990, the U. S. Congress found that offerings by these kinds of issuers were common vehicles for fraud and manipulation in the market for penny stocks which undermines investor confidence and inhibits legitimate capital formation by small issuers and other companies. ² The Commission has adopted several rules, as Congress directed, to deter fraud in connection with registered offerings by blank check companies. ³ The Commission has also excluded blank check companies from eligibility for several exemptions from Securities Act registration requirements. ⁴

Each of your scenarios suggests the availability of Rule 144 or Section 4(1) of the Securities Act following the lapse of some period of time following the issuance of shares in the blank check company regardless of whether a merger has occurred. In a number of cases, promoters of these issuers appear to be in the business of creating blank check companies, then gifting or selling the securities of the companies without registration, either directly or through intermediaries.

Section 4(1) exempts transactions not involving issuers, underwriters or dealers. The availability of the exemption depends upon the facts and circumstances of each particular situation, which the staff generally is not in a position to determine. Nonetheless, transactions in blank check company securities by their promoters or affiliates, especially where they control or controlled the "float" of the "freely tradable" securities, are not the kind of ordinary trading transactions between individual investors of securities already issued that Section 4(1) was designed to exempt. ⁵

Furthermore, as the Commission has indicated, purchasers who are mere conduits for a wider distribution of the securities are "underwriters." When they do sell, these purchasers assume the risk of possible violation of the registration requirements of the Securities Act and consequent civil liabilities. Persons engaged in the business of buying and selling securities who function in this capacity are subject to careful scrutiny. ⁶

It is our view that, both before and after the business combination or transaction with an operating entity or other person, the promoters or affiliates of blank check companies, as well as their transferees, are "underwriters" of the securities issued. Accordingly, we are also of the view that the securities involved can only be resold through registration under the Securities Act. ⁷ Similarly, Rule 144 would not be available for resale transactions in this situation, regardless of technical compliance with that rule, because these resale transactions appear to be designed to distribute or redistribute securities to the public without compliance with the registration requirements of the Securities Act. ⁸

Each of your scenarios illustrates what we believe to be a scheme to evade the registration requirements of the Securities Act. Consequently, it is our view that the resale of the shares in scenarios 1 through 7 would require registration.

In addition, with regard to scenario 6, we are of the view that Rule 701 is not available for issuances to companies or entities, but only to individuals. In view of the business of a blank check company which generally has few or no employees, it seems unlikely that reliance upon this exemption would be appropriate. It is our view that Rule 701 would generally not be available to blank check companies for issuing shares to their consultants or advisors.

Moreover, we have been advised by staff of the Division of Market Regulation that Rules 101 and 102 of Regulation M ⁹ impose restrictions on issuers, selling shareholders and distribution participants when they effect transactions in securities that are part of a distribution. Generally, a distribution exists when a sufficient magnitude of shares is being sold and special selling efforts are employed to sell these shares. If a distribution exists, the persons involved in the distribution are prohibited from bidding for or purchasing the securities in distribution. The rule covers persons selling securities, their affiliates, and other participating in the distribution. Persons selling in the manner described in your letter should carefully analyze the facts surrounding the sales to determine whether the security being sold is in distribution for purposes of Regulation M. This analysis should specifically consider the actions taken by any persons assisting with the transactions. In particular, selling through a market maker into an illiquid market raises heightened concerns regarding compliance with Regulation M. ¹⁰

Because these positions are based upon representations made in your letter, any different facts or conditions might require a different conclusion.

Sincerely,

Richard K. Wulff, Chief

Office of Small Business

SEC_CODE_REF_0090001192884