trolled by or is under common control with the issuer) directly or indirectly purchases from or sells for stockholders who acquired securities in a Rule 133 transaction, under circumstances involving a distribution.

III. We further recommend that consideration be given to the adoption of rules and forms which will, to an appropriate degree, make possible the employment of proxy material required to be filed pursuant to section 14(a) of the Exchange Act, or which substantially complies with the provisions of Regulation 14 even though not required to be filed with the Commission pursuant thereto, as part of the prospectus to be filed in satisfaction of the registration requirements for distribution of securities of the character referred to in II.

These recommendations were based upon certain conclusions reached by the staff after a detailed discussion of the relevant authorities, prior actions, and a review of arguments and comments received or otherwise noted. These conclusions are:

Conclusion I

We do not agree with the proposition that the transactions described in Rule 133 do not involve a "sale" within the meaning of that term as defined in section 2(3) of the Securities Act and that, theretofore, the Securities Act has no application to such transactions. We reach this result essentially for two basic

reasons:

(1) the concept of "sale" as defined in section 2(3) is broader than the commercial or common-law meaning of that term, and embraces a number of situations which would not be regarded as sales in the commercial sense but fall within the purposes of the Securities Act; and

(2) the transactions described in Rule 133 do not, as is often said, occur solely by operation of law and without the element of individual consent by security holders, but on the contrary are basicly contractual in their foundation, reflecting essentially contractual relationships among security holders and between security holders and corporations. Conclusion II

We believe that the Commission has the

power to promulgate or to continue in effect rules of interpretation or rules of definition which have the effect of declaring that transactions are not "sales" for purposes of sections 4 and 5 of the Act where the Commission concludes on the basis of its experience and the over-all structure of the Act that the procedural and liability provisions of the Act as they affect issuers, underwriters and dealers would not operate reasonably and effectively in such transactions.

Conclusion III

We believe, having regard to the nature, purposes and operation of the procedural provisions of sections 4 and 5, the civil liabilities for failure to comply with such procedures, and the operation of certain of the statutory exemptions from section 5, that Rule 133 represents a reasonable interpretation of the Act in the application of section 5, one which is not inconsistent with the broad purposes of the Act as derived from its structure and history, and a proper exercise of the Commission's defining and rule-making powers thereunder, particularly where, as here, this result reflects a consistent administrative interpretation over a period of almost 24 years.

Conclusion IV

We believe that a stockholder acquiring a new security in a transaction falling within Rule 133 "has purchased" that security from an issuer within the meaning of section 2(11) and accordingly certain stockholders may be defined as underwriters if they acquire the security with a view to distribution, and that in many cases this result conforms to the structure and policy of the Act. We also believe, however, that ordinary investors not in a control relationship with any corporation participating in the transaction should not be defined as underwriters, although participation by the issuer in resales by them should require registration by the issuer. Rules embodying these distinctions should also make appropriate provision for what are essentially trading transactions by security holders, included in the definition of "underwriter," who are not in a control relationship to the issuer.

*

SECURITIES ACT OF 1933

The Securities and Exchange Commission today made public a preliminary report submitted to it by Philip A. Loomis, Jr., Director of its Division of Trading and Exchanges, discussing the results of an inquiry into the circumstances surrounding the distribution of "hot issues," those issues which on the first day of trading, frequently the offering date, sold at a substantial premium.

The text of the preliminary report follows: Recently the Commission directed the staff to make a study into the circumstances surrounding price increases following immediately upon the public offering of certain issues registered with the Commission under the Securities Act of 1933 or offered pursuant to Regulation A which conditionally exempts certain small issues from registration. Most of these issues were low priced, had no public market prior to the offering and often involved companies in the electronics, missile and related defense fields. These are so-called "glamour" stocks for which there has recently been a strong public demand.

During the course of this study certain practices in connection with the distribution of these issues have been disclosed which, in the opinion of the staff, may involve violations of the Federal securities laws. Although the study is continuing, it is believed that these practices should be called to the attention of the financial community in order that violations of law may be avoided.

The practices in question involve a combination of some or all of the following elements:

1. In addition to allotments of the offered securities to his own customers and to selling group dealers, if any, the underwriter may allot a portion of the offering at the public offering price to trading firms active in the over-thecounter market. These firms are expected to

1 In some instances, the name of the company had recently been changed to include some word which would suggest a connection with these activities.

commence making a market in such securities at or immediately after the start of the public offering. Some of these firms sell their allotments at prices substantially in excess of the public offering prices stated in the prospectus, and in some cases bid for and purchase the security while they are distributing their allotments. The inquiry also discloses that such distributions may be made by these firms without any use of a prospectus.

In one recent offering, which almost doubled in price on the first day of trading, over 13 percent of the entire offering was sold by the underwriters at the public offering price to four broker-dealers and one of these broker-dealers sold out its entire allotment in the course of trading activities within 3 weeks of the offering date at substantially higher prices. In another "hot issue" offering the principal underwriter sold substantial amounts of its participation at the public offering price of $3 per share to several broker-dealers and on the first day of trading, six of these firms appeared in the "sheets" of the National Daily Quotation Service with bids and offers ranging from 534 to 714.

2. Underwriters and selling group dealers may allot a substantial portion of the securities acquired by them to partners, officers, employees or relatives of such persons ("insiders"), to other broker-dealers with whom they may have reciprocal arrangements or to "insiders" of such other broker-dealers. Such allotments are made notwithstanding the fact that customers of such firms are unable to obtain a part of the original distribution and therefore could only purchase the securities in the market at the higher price.

In one recent offering, which more than doubled in price on the offering date, the selling group allotted over 28 percent of its total participation to "insiders." One member of that selling group diverted to "insiders" over 75 percent of its 3,000 share allotment of the 100,000 share offering, and another sold al

most 50 percent of its 5,000 share allotment to "insiders." Underwriters have indulged in the same practice. The underwriters in a recent offering of an electronics stock diverted almost 22 percent of the entire offering to "insider" accounts. In another offering one of the underwriters diverted over 87 percent of its participation to "insider" accounts and another sold 47 percent to such accounts.

The foregoing practices may involve violations of several requirements of the Federal securities laws:

(a) The registration statement and prospectus, or the offering circular may be materially misleading because of the failure to disclose the actual plan of distribution and the marketing arrangements for the issue. The usual representations in these documents imply that the securities will be offered to the public by the underwriters and selected dealers at the public offering price. These disclosures are misleading if, in fact, substantial blocks of shares are not to be offered to the public at the prospectus price, but rather are to be allotted to "insiders," trading firms and others who may be expected to reoffer at a higher price.1

(b) The staff is of the opinion that the functions and activities of the trading firms described above constitute part of the distribution process and are of such a nature as to make them "underwriters" within the meaning of section 2(11) of the Securities Act of 1933. The failure to identify them as "underwriters," to state the profits realized through these activities and to describe the effect of

In the case of an offering under Regulation A, such deferred distributions at prices substantially in excess of the indicated offering price may result in an offering exceeding the $200,000 limit of the exemption and therefore constitute a violation of section 5(a) of the Securities Act of 1933 for the entire offering. See e.g., Lewisohn Copper Corp., Securities Act Release No. 3907.

2 "Insiders" and other persons to whom shares are alloted with the understanding that the shares will be reoffered may also be "underwriters." See Securities and Exchange Commission v. Chinese Consolidated Benevolent Association, 120 F. 2d 738 (C.A. 2d, 1941); Securities and Exchange Commission v. Culpepper et al., C.A. 2d Sept. 10, 1959 (Docket No. 25242).

3 In any event, these trading firms as dealers must use a prospectus for the 40 day period prescribed in the third clause of section 4(1) of the Securities Act of 1933. (Third clause of section 4(1) is now section 4 (3) as amended Aug. 20, 1964.)

The Commission and the courts have had frequent occasion to condemn various schemes which have an analogous effect upon the public. Cf. Otis & Company v. Securities and Exchange Commission, 106 F. 2d 579 (C.A. 6th, 1939); United States v Brown, 79 F. 2d 321 (C.A. 2d, 1935): Rickard Ramore Gold Mines, Ltd., 2 S.E.C. 377 (1937): and Canusa Gold Mines, Ltd., 2 S.E.C. 548 (1937).

these activities makes the prospectus a misleading document. As participants in a distribution, these firms are required by section 5(b) of the Act to deliver the prospectus to investors.3

(c) In the above cases, violations of the anti-fraud provisions of the Securities Act and the Securities Exchange Act may be involved. The public is led to believe by the prospectus, selling solicitations and newspaper advertisements that a stated number of shares are being publicly offered at the prospectus price when, in fact, they are not and the initial supply in the market is being restricted. To add to this initial deception statements are circulated that the issue has been heavily oversubscribed. Believing that public demand has exhausted the issue, and observing the market action, produced at least in part by the nature of the distribution arrangements, the public is induced to buy the security in the market at premium prices-the "market" being one created and under the control of persons actively engaged in a distribution. Purchases by the public raise the price further and give "insiders" and others an opportunity to make substantial profits at the expense of a public unaware of the actual method of distribution.

(d) The practice described above of selling stock at the public offering price to trading firms for the purpose of making an over-thecounter market for the security may result in violations of Rule 10b-6 adopted under the Securities Exchange Act of 1934. That rule prohibits, among other things, an underwriter or a participant in a distribution from bidding for or purchasing securities being distributed or any other securities of the same class until he has completed his participation in the distribution. Since these trading firms are participating in a distribution while selling their allotments to the public, any open market purchases while so participating accordingly violate the rule. In this connection, if securities are allotted at the public offering price to "insiders" of trading firms or others with a view to resale by such persons to or through such firms in the course of trading activities, the distribution of such securities would not have been completed within the meaning of Rule 10b-6.

(e) If a broker-dealer engaging in the above activities should represent that such security was being sold "at the market" or at a price related to the market, then his activity could also involve a violation of Rule 15c1-8 unless the broker or dealer knew or had reasonable grounds to believe that there was a market for such security other than that made, created, or controlled by such broker or dealer or by any person associated with him in the distribution.

The staff also considers it appropriate to point out that pursuant to the authorization of the Commission it has submitted to the National Association of Securities Dealers, Inc., for such disciplinary action as the Association considers to be appropriate, the evidence obtained by the staff with respect to possible "free riding" by some members of such Association. The staff has been informed by such Association that it is reviewing its policy with respect to "free riding" and the enforcement of

SECURITIES ACT OF 1933

such policy to determine what further steps, if any, it should take in the matter.

These practices should be called to the attention of the financial community since, in the view of the staff, they may involve violations of the Federal securities laws. The staff is continuing its inquiry into these and other arrangements, understandings and practices in connection with the distribution of various issues. The staff will, of course, recommend to the Commission whatever further action it considers to be appropriate under the circumstances as a result of this inquiry.

1 Under the Rules of Fair Practice of that Association, a member is required to observe "high standards of commercial honor and just and equitable principles of trade." The Association has issued an interpretation stating in substance that it is contrary to that rule for a member of an underwriting and distributing group "to sell all or any part of his participation, during the period of original distribution, at a price above the public offering price" or "to refuse to make, or refrain from making, a public offering of all or any part of his participation in order to make an extra profit, over and above his normal compensation as a member of such group." These practices are labeled "free riding."

Section 5(c) of the Securities Act of 1933 makes it unlawful for any person, directly or indirectly, to use Federal jurisdictional means. -the mails, or the means or instruments of transportation or communication in interstate or foreign commerce-to offer to sell or to solicit an offer to buy a security unless a registration statement with respect to such security has been filed with the Securities and Exchange Commission. Under section 5(a) it is unlawful by jurisdictional means for any person, directly or indirectly, to sell such security or to carry or cause to be carried any such security for the pupose of sale or for delivery after sale unless the registration statement has become effective. The second clause of section 4(1)1 of the Securities Act of 1933 exempts from the registration and prospectus provisions of the Act "transactions by an

issuer not involving any public offering." These provisions are intended to make effective a basic statutory objective that the registration and prospectus provisions of section 5 of the Act shall apply to distributions of securities to the public by an issuer, underwriter or dealer. Apart from exemptions for certain securities and transactions, other provisions of the Act limit the application of the registration provisions to distributions effected by or on behalf of an issuer or on behalf of a person in a control relationship with the issuer.

Questions have arisen as to the application of the exemption afforded by section 4(1)1 to a public offering of convertible securities by or on behalf of any person who purchased the convertible security directly or indirectly from

1 Second clause of section 4(1) is now section 4(2), as amended August 20, 1964.

the issuer in a nonpublic transaction, or to a public offering of the underlying securities received upon conversion of the securities so placed. On December 2, 1959, the Commission published Securities Act of 1933 Release No. 4162 in which it invited comment upon a new Rule 155 which had been proposed by the staff of the Commission to clarify the application of the statute in these circumstances.

Release No. 4162, to which reference is made, contains a summary of the staff conclusions and recommendations which form the basis for the proposed rule. Briefly restated, the staff view is that, "For purposes of the provisions of sections 2(11), 4(1) and 5 of the Securities Act, the transaction involved in a private placement by an issuer of a convertible security is not completed until the disposition of the underlying securities is determined" and that, in consequence, no exception from the registration and prospectus provisions of the Act is available for a public offering of an immediately convertible security so issued, or for the underlying security received upon conversion unless the circumstances of acquisition, retention and disposition of the under-lying security are such that the persons offering the underlying security are not underwriters within the meaning of section 2(11) of the Act.

The Commission has received helpful letters of comment. A number of the suggestions made have been incorporated in a revision of the proposal as set forth below.

Rule 155. Definition of "Transactions by an Issuer Not Involving Any Public Offering" in Section 4(1) for Certain Transactions

(a) The phrase "transactions by an issuer not involving any public offering" in section 4(1) of the Act shall not include (1) any public offering of a security, which at that time is immediately convertible into another security of the same issuer, by or on behalf of any person or persons who purchased the convertible security directly or indirectly from an issuer as part of a nonpublic offering of such security, or (2) any public offering by or on behalf of any such person or persons of the other security acquired on conversion of a

convertible security, unless the other security was acquired under such circumstances that such person or persons are not undewriters within the meaning of section 2(11).

(b) The phrase "transactions by any person other than an . . . underwriter" in section 4(1) of the Act shall, for the purposes of this rule, be deemed to include transactions by the initial, and any intermediate, holder of the convertible security or of the underlying security who (1) has not acquired the convertible or underlying security with a view to the distribution of either of them, and (2) is not effecting or causing to be effected, and has not arranged for a public offering of either security within the meaning of and subject to paragraph (a) of this rule.

(c) This rule shall apply to transactions of the character described in paragraph (a) only with respect to convertible securities issued after February 7, 1962 the effective date of the rule.

Several of the letters received also raised questions as to the application of the proposed rule to various situations and requested that the Commission publish, prior to any final action upon the proposed rule, a further release treating with these questions. The following paragraphs refer to the more important of these questions and to the reasons advanced by the staff for the additional provisions reflected in the revised proposal.

I. Notes or debentures convertible into similar trust indenture securities

The question has been raised whether the proposed rule would relate to "... an unsecured note or debenture issued in a bona fide private placement [which] provides that the holder thereof may, if he so desires, break down the note or debenture into a number of small pieces issued under a trust indenture meeting the requirements of the Trust Indenture Act, so as to make it possible for such purchaser or someone else at a later date to effect resales, in such smaller units, of the notes or debenture . . It is understood that transactions initially are effected in this manner to avoid certain taxes, the drafting of an indenture, and payment of the fees of an indenture trustee, all of which are not then necessary but might be required