Securities Act Release No. 7024

Exchange Act Release No. 33095

October 25, 1993

Penny Stock Definition for Purposes of Blank Check Rule.

ACTION: Final Rule.

SUMMARY: The Commission is revising the definition of "penny stock" in Rule 3a51-1 under the Securities Exchange Act of 1934 ("Exchange Act") for purposes of its rules relating to registration statements filed by blank check companies under the Securities Act of 1933 ("Securities Act"). The revision makes the exclusion from the penny stock definition for securities priced at five dollars or more inapplicable to the determination of whether a securities offering is subject to section 7(b) of the Securities Act and Rule 419 thereunder.

EFFECTIVE DATE: [Insert date of publication in the Federal Register]. The revision will be applicable to registration statements filed by blank check companies on or after this date, as well as to registration statements filed by blank check companies that are pending on such date.

FOR FURTHER INFORMATION CONTACT: Richard Wulff, Division of Corporation Finance (202) 272-2644.

SUPPLEMENTARY INFORMATION: On July 2, 1993, the Commission proposed to revise its penny stock definition, Rule 3a51-1 ¹ under the Exchange Act, ² as applicable to blank check offerings registered with the Commission under the Securities Act. ³ Under the proposal, the Commissions rules governing blank check registration statements would apply regardless of the price at which the securities were offered. ⁴ The revision is being adopted as proposed.

I. DISCUSSION

On April 13, 1992, the Commission, pursuant to the Securities Enforcement Remedies and Penny Stock Reform Act of 1990, ⁵ adopted rules relating to Securities Act registration statements filed by blank check companies. ⁶ For purposes of Securities Act registration statements, a blank check company is a development stage company ⁷ that is issuing a penny stock and that has no specific business plan or purpose or has indicated that its business plan or purpose is to merge with an unidentified company. ⁸ Penny stock was defined in new section 3(a)(51) of the Exchange Act to include most equity securities not excluded pursuant to Commission rulemaking. ⁹ In general, under Rule 3a51-1, certain equity securities--including securities priced at five dollars or more, securities subject to last sale reporting and listed on a national securities exchange or quoted on NASDAQ, and securities of an issuer that meets either a minimum net tangible assets or revenues test--have been excluded from the definition of "penny stock." ¹⁰

Congress found the offerings of blank check companies to be common vehicles for fraud and manipulation in the penny stock market and directed the Commission to develop disclosure-based regulations so that investors might make informed investment decisions with respect to these securities offerings. Thus, as contemplated by section 7(b) of the Securities Act, ¹¹ Rule 419 ¹² prescribes special requirements with regard to the registration statements filed by blank check companies. The rule (1) requires issuers to provide timely and specific disclosure about companies to be acquired and the application of proceeds; (2) places limits on the use of proceeds and distribution of the securities by way of a mandatory escrow or trust procedure until the disclosures have been made through a post-effective amendment; and (3) provides a refund right to investors. The provision is strengthened by Rule 15g-8, ¹³ which makes unlawful transactions of any kind in securities that are contained in a Rule 419 escrow or trust account.

As discussed in the Proposing Release, it has become apparent that, for blank check offerings, the five dollar price threshold presents an easy mechanism for avoiding the regulatory scheme contemplated by Congress. Applying the five dollar exclusion contained in Rule 3a51-1 to offerings by blank check issuers undercuts the investor protection purpose of the blank check rules.

Accordingly, the Commission is revising the definition of penny stock, solely for purposes of section 7(b) of the Securities Act and Rule 419 thereunder, so that the five dollar price exclusion provided by Rule 3a51-1 will not prevent offerings registered under the Securities Act by blank check companies from being subject to Rule 419. ¹⁴ The five dollar price exclusion will continue to apply for all other purposes, including Rules 15g-2 through 15g-6 and 15g-9 under the Exchange Act. Furthermore, the other exclusions in Rule 3a51-1 from the definition of penny stock, which turn on characteristics other than pricing, remain unchanged.

A number of blank check registration statements filed with the Commission have raised another definitional issue, which concerns the application of one of the other exclusions from the definition of penny stock--the exclusion for securities whose issuer has net tangible assets in excess of $2 million if in continuous operation for more than 3 years, or $5 million if less than 3 years. For an issuer to come within this exclusion, support for the level of net tangible assets must be provided through certified financial statements.

Questions have been raised with respect to whether an offering by a blank check issuer that is underwritten on a firm commitment basis, with the proceeds to exceed $5 million, must comply with Rule 419. Although the closings for these offerings typically do not occur for a short period of time following effectiveness of the registration statement and no audited balance sheet could be produced prior to that time, the Commission has been urged to permit issuers to use the proceeds of such a firm commitment underwriting in calculating the issuers net tangible assets, solely for purposes of determining whether compliance with the blank check rule is required. An issuer involved in firm commitment offerings typically can secure an audited balance sheet following closing in order to provide support for its level of net tangible assets, and such issuers have indicated that they are willing to file this information under cover of Form 8-K. ¹⁵

The commission has determined that an issuer that otherwise would be subject to Rule 419 will be permitted to aggregate the proceeds of a firm commitment underwriting ¹⁶ with its other tangible assets solely in order to determine whether the offered security must comply with Rule 419, provided that the issuer files an audited balance sheet reflecting net tangible assets (including the proceeds of the offering) in excess of the threshold promptly after the closing date and files such balance sheet under cover of Items 5 and 7 of Form 8-K. Filing of the required Forms 8-K will be monitored by the Commission staff. Of course, an offering that is not a bona fide firm commitment may not be used as a device to evade compliance with Rule 419.

A broker-dealer effecting transactions in a security of such an issuer must, however, continue to comply with Rules 15g-2 through 15g-6, and with Rule 15g-9. ¹⁷ Regardless of the anticipated proceeds of an offering, in order for a broker-dealer to rely on the exclusion from the definition of penny stock based on the issuers net tangible assets for the purpose of these rules, the broker-dealer must obtain and review audited financial statements of the issuer demonstrating the issuers net tangible assets, and have a reasonable basis for believing such statements are accurate in relation to the date of any such transactions, as required by Rule 3a51-1(g)(3).

II. EFFECTS ON COMPETITION

As required by section 23(a) of the Exchange Act, ¹⁸ the Commission has specifically considered the impact this rulemaking action would have on competition and has concluded that no significant burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act will result.

III. SUMMARY OF THE FINAL REGULATORY FLEXIBILITY ANALYSIS

The Commission has prepared a Final Regulatory Flexibility Analysis in accordance with the Regulatory Flexibility Act. ¹⁹

A copy of the Final Regulatory Flexibility Analysis may be obtained from Twanna M. Young, Office of Small Business Policy, Division of Corporation Finance, Securities and Exchange Commission, 450 Fifth Street, N. W., Stop 7-8, Washington, D. C. 20549, (202) 272-2644.

IV. EFFECTIVE DATE

The revision will be effective upon publication in the Federal Register and will apply to all registration statements of blank check companies filed after such date, as well as those currently pending with the Commission.

Pursuant to section 553(d) of the Administrative Procedure Act ²⁰, the Commission finds that good cause exists for making the revision effective less than 30 days after publication. In light of the history of demonstrated abuses in connection with blank check offerings, Congress established, as part of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990, a special regulatory scheme to provide substantive protections to investors. While the Commission has previously adopted blank check rules to carry out this statutory mandate, experience has demonstrated that full implementation of the Congressional mandate has been frustrated by the ability of issuers to avoid the blank check rules by pricing their securities above five dollars. The revision will prevent this method of circumvention. Because of the serious Congressional concerns about fraud and manipulation in connection with blank check offerings, the Commission believes there should be no further delay in fulfilling the statutory mandate. Issuers and other interested persons have been on notice since the Commissions issuance of the Proposing Release on July 2, 1993 of the possible revision to the definition of "penny stock" for blank check issuers.

V. STATUTORY BASIS, TEXT OF REVISION AND AUTHORITY

The amendment to the Commissions rule is being made pursuant to sections 7(b) and 19(a) of the Securities Act and sections 3(a)(51)(A) and 23(a) of the Exchange Act.

List of Subjects in 17 CFR Part 240

Reporting and recordkeeping, Securities.

For the reasons set out in the preamble, title 17, chapter II of the Code of Federal Regulations is amended as follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934

1. The authority citation for part 240 continues to read in part as follows:

AUTHORITY: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78i, 78j, 78l, 78m, 78n, 78o, 78p, 78s, 78w, 78x, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless otherwise noted.

2. In §240.3a51-1, revise the introductory text of paragraph (d) to read as follows:

(d) Except for purposes of section 7(b) of the Securities Act and Rule 419 (17 CFR 230.419), that has a price of five dollars or more;

By the Commission.

¹ 17 CFR 240.3a51-1.

² 15 U. S. C. 78a et seq.

³ 15 U. S. C. 77a et seq.

⁴ Release Nos. 33-7006; 34-32575 (July 2, 1993) [58 FR 37445] (the "Proposing Release"). The nine comment letters received are available for inspection and copying at the Commissions Public Reference Room in Washington D. C. by referring to File No. S7-20-93.

⁵ Pub. L. No. 101-429 (October 15, 1990).

⁶ Release No. 33-6932; 34-30577; IC-18651 (April 13, 1992) [57 FR 18037].

⁷ Rule 1-02(h) of Regulation S-X, 17 CFR 210.1-02(h), defines such a company as one that is devoting substantially all of its efforts to establishing a new business in which planned principal operations have not commenced, or have commenced but there has been no significant revenue therefrom.

⁸ See section 7(b) of the Securities Act, 15 U. S. C. 77g(b); Rule 419(a)(2), 17 CFR 230.419(a)(2).

⁹ 15 U. S. C. 78c(a)(51)(A).

¹⁰ See Release No. 34-30608 (April 20, 1992) [57 FR 18004].

¹¹ See also H. Rep. No. 101-617 at 34-35.

¹² 17 CFR 230.419.

¹³ 17 CFR 240.15g-8.

¹⁴ As a result, this exclusion also will be unavailable for purposes of Rule 15g-8, which refers to Rule 419.

¹⁵ 17 CFR 249.308.

¹⁶ The offering must be a bona fide firm commitment offering, wherein the risk of success of the offering is not placed on the issuer. For instance, a "market out" clause, which permits an underwriter to terminate its obligation to purchase the offered securities based upon an inability to market the securities or the occurrence of nonmaterial adverse events affecting the issuer or the securities markets in general, is inappropriate in the context of a firm commitment underwriting. See Letter regarding First Boston Corporation, [1985-86] Fed. Sec. L Rep. (CCH) 78,152 (Aug. 2, 1985).

¹⁷ 17 CFR 240.15g-2 to 240.15g-6 and 240.15g-9. Rule 15g-9 was formerly designated as Rule 15c2-6. See Release No. 34-32576 (July 2, 1993). Rules 15g-1 and 15g-9(c), 17 CFR 240.15g-1 and 240.15g-9(c), may provide exemptions in certain circumstances.

¹⁸ 15 U. S. C. 78w(a).

¹⁹ 5 U. S. C. 604.

²⁰ 5 U. S. C. 553(d)(3).