The Internet
M. Louise Rickard *Joseph Kershenbaum
Securities offerings made on the Web are subject to a panoply of federal and state regulations. But is the paper model appropriate for online transactions?
The National Law Journal (p. B04)
Monday, June 8, 1998
Despite the abundance of information on the Internet, the expectation that securities offerings in cyberspace would create the stock market of tomorrow has not yet been met. While established public companies are beginning to allow investors to purchase stock online through direct stock purchase plans, offerings by small and nonpublic companies have been limited in scope because of regulatory restraints. Consequently, a new course of action is required for the Internet to be employed effectively as a capital-raising vehicle.
The use of the Internet as a medium for securities offerings ranges from simple promotions disseminating very basic information about an offering to actual offers and sales of securities. Of the latter, generally only small, undercapitalized companies that previously have not publicly offered securities have taken advantage of the opportunity to offer and sell securities on the Internet.
A fundamental reason involves the issuer's visibility--or rather the lack of it. Nonpublic companies have offered securities on the Internet using two methods. An issuer may offer its securities in an online private placement, although purchasers must be accredited or sophisticated investors which has limited the use of this method.
More commonly, an issuer seeks capital through a direct public offering, in which shares are offered directly to potential investors via online resources, telephone or in-person marketing, bypassing underwriters. The end result is that the most common method used to sell securities on the Internet is at odds with the issuer's need to raise its visibility because the direct public offering excludes investment bankers.
A company must comply with both federal and state law requirements to offer and sell securities over the Internet. Most companies registering securities for an online direct public offering would file a Form S-1, Form SB-1 or Form SB-2 registration statement with the Securities and Exchange Commission. Form S-1 is the most common registration form used in connection with initial public offerings, but the cost of a traditional offering, which includes preparing a registration statement, have been beyond the ability of most Internet-based issuers.
Forms SB-1 and SB-2 are alternative forms for the registration of securities used by a small business issuer. A company may offer up to $10 million of its securities using a Form SB-1 and may offer an unlimited dollar amount of its securities using a Form SB-2. Forms SB-1 or SB-2 still may be costly and time-consuming for very small issuers that seek to offer and sell securities in a direct public offering.
As a practical matter, most companies have done Internet-based issuances under exemptions from the registration requirements of the Securities Act. Possible exemptions for such an issuance include: a Sec. 4(2) private-offering exemption, a Sec. 4(6) accredited-investor exemption, a Regulation A exemption, rules 504, 505 and 506 of Regulation D, a Sec. 3(a)(11) intrastate-offering exemption and a Rule 1001 California limited-offering exemption, among others. Direct public offerings, however, most commonly have occurred pursuant to exemptions for small offerings under Regulation A and Rule 504 under Regulation D.
Under Regulation A, a company may publicly offer up to $5 million of its securities within a 12-month period. Although Regulation A is an exemption from registration under the Securities Act, the issuer still must file a Form 1-A offering statement with the SEC, much like filing a registration statement in a registered offering. Unlike a registered offering, however, Regulation A permits a company to "test the waters" before filing the offering statement to determine if there is interest in a proposed offering, and advertising, with restrictions, is permitted after a Form 1-A is filed. In a registered offering on Form S-1, for example, testing the waters is not permissible, and any writing other than the statutory prospectus, and certain limited tombstone announcements concerning the offering, is prohibited before the registration statement becomes effective. The benefit of Regulation A to small issuers is the relative simplicity of Form 1-A's disclosure requirements and its less stringent financial statement requirements compared to Form S-1.
Regulation D consists of a set of rules that provide for exemptions from registration for three limited securities offerings. A company may offer and sell its securities under either Rule 504, 505 or 506, which contain the specific exemption requirements. Companies also must satisfy the conditions of Rules 501 and 502, which contain definitional requirements and general conditions that must be met for a Regulation D offering relating to the nature of the purchasers, the delivery of information, the manner of the offering and restrictions on the resale of the securities offered. Additionally, a company must file a Form D with the SEC pursuant to Rule 503.
Under Rule 504, a company may sell up to $1 million of securities within a 12-month time period. The company may generally solicit investors and generally advertise the securities, and may sell them to any investor. There is no limit to the number of investors who may purchase the securities. The securities are not restricted securities.
Several of the other exemptions offer potential as financing vehicles for a company doing an Internet-based issuance, but as a practical matter, their restrictions prevent such use.
Under Rule 505, a company may sell up to $5 million of securities within a 12-month period. While similar to Rule 504, it has three key differences. First, a company may not generally solicit investors or generally advertise the offering. Second, there may be no more than 35 nonaccredited purchasers of securities in a Rule 505 offering. To be accredited, an individual must have a net worth (or a joint net worth with a spouse) of more than $1 million when purchasing the securities or an income of more than $200,000 (or a joint income of more than $300,000) in each of the previous two years. Third, the securities will constitute "restricted securities" and will be subject to resale limitations. For these reasons, the offering essentially is limited to wealthy investors (beyond the 35 nonaccredited investors) the company knows or can locate without a general solicitation--a tough, if not impossible, prospect for a small company seeking capital online.
Rule 506 is similar to Rule 505, except that a company may raise an unlimited amount of capital in a Rule 506 offering and nonaccredited purchasers also must be sophisticated, which means they must have a certain level of knowledge and experience in financial matters. As with Rule 505, Regulation D restrictions frustrate Internet-based issuers' ability to use Rule 506 to seek capital online.
Under rule 1001, a company may offer and sell up to $5 million of securities that satisfy the conditions of Sec 25102(n) of the California Corporations Code. Individual purchasers must be "qualified purchasers" who, like accredited investors, must meet minimum net-worth and income tests. Some general solicitation containing specified information is allowed, but resales of the securities are restricted. Once again, as with rule 505 and 506 offerings, Rule 1001's restrictions impede its viability for a company wishing to raise capital on the Internet.
The SEC adopted Rule 147 to provide an objective procedure for satisfying the requirements of the Sec. 3(a)(11) intrastate offering exemption, in which a company may offer and sell securities in only one state. Under Rule 147, the company must be a resident of and be doing business in the state in which all offers and sales are made. No federal restriction exists either regarding the maximum offering amount of securities that may be offered or the time period in which they may be offered, although state-law restrictions may apply. Subject to state restrictions, the company may generally solicit investors and may generally advertise the securities. For nine months from the date the offering ended, the securities may be resold only to residents of the state in which the offering occurred. Restricting offers and sales of securities to one state compounds the basic difficulty of finding investors for an online direct public offering and thus greatly limits a company's use of Rule 147 for an Internet-based offering.
Companies must also comply with state securities, or "blue sky," laws, which vary from state to state. A uniform program has developed, however, which promotes the ability of small companies to raise capital by removing regulatory burdens. Companies exempt from registration with the SEC under Regulation A, Rule 504 or Rule 147 may comply with state laws by doing a small company offering registration, or SCOR, with the state or states in which they are offering securities. They may do so by filing a Form U-7, which provides for the uniform treatment of registrations of such small company offerings. A company utilizing the SCOR program may raise up to $1 million, with certain restrictions.
Most states have adopted regulations or published policy statements which provide for some sort of exemption for offers made over the Internet. However, this type of regulation or policy is not a true exemption for Internet offers and sales. Rather, it helps companies to avoid making an offer in states without an available exemption.
In releases in October 1995 and May 1996, the SEC provided guidance on how prospectus and proxy delivery can be achieved via electronic means, but it derived its approach by analogy to the current method--paper delivery. However, because of the Internet, there is now more information, it is cheaper to disseminate and is continuously available. In the context of a public offering of securities on the Internet, the analogy to paper delivery, and the concepts of gun-jumping (improper soliciting activities before or during the offering registration process) and illegal prospectuses (impermissible written offering materials before a registration statement becomes effective) are, at best, an uneasy fit with the flow of information on the Internet.
The current view is that Web site information may constitute an illegal prospectus during the pendency of a registration statement. To avoid violations of the Securities Act, issuers are counseled to avoid hyperlinks to a preliminary prospectus, and fictions of an "electronic envelope" are concocted to make sure that the preliminary prospectus is "sealed" from the issuer's Web site. Issuers are counseled to "clean up" Web sites so that communications on the site are not construed as conditioning the market or gun-jumping.
But a more comprehensive approach is necessary, one that would recognize the electronic media of the Internet as a permanent and growing force in the marketplace. One proposal, suggested by the Wallman Commission, an advisory committee headed by former SEC Commissioner Steven Wallman, is to create a company-based registration model rather than the present, transaction-based approach. An issuer would be allowed to register an unlimited amount of securities on a new registration form which the issuer would update by periodic reports. Filing fees would be paid as securities are sold. This method would eliminate gun-jumping and the differences between public and private offerings.
However, it would benefit only publicly traded companies--seasoned issuers with track records that would enable them to attract capital anyway. All the problems presently confronting small issuers in raising capital would remain.
Another solution would be for Congress to dispense with the regulation of offers entirely and to regulate only sales. Communications constituting an offer would still be subject to the antifraud provisions of the securities laws, but they would not be subject to gun-jumping and statutory prospectus requirements. This approach would allow an issuer engaged in a registered public offering to use all media, including the Internet, to test the waters or offer securities without violating the registration provisions of the Securities Act. Full and complete disclosure still would be required in the form of a disclosure document or prospectus on which an investor purchasing the securities should rely.
Yet another approach would be to eliminate the ban on public solicitation and advertising for exempt offerings to qualified investors, similar to that of the Rule 1001 California limited-offering exemption. But limiting the pool of investors to qualified purchasers who must meet minimum net-worth and income tests, as Rule 1001 requires, would restrict the universe of investors. Additionally, Rule 1001's restrictions on resales of securities, decreasing their liquidity, could reduce the number of interested investors rather than attract capital to an issuer. Despite these limitations, this approach would give small issuers the ability to access sophisticated investors quickly and more cheaply, and at least would afford these issuers the means to determine if interest in the marketplace exists for their ventures.
For this alternative to be viable, all 50 states would have to adopt a virtually identical exemption.
Internet-based investment bankers have arisen, primarily hosting prospectuses at their Web sites for prospective issuers or offering consulting services to nonpublic issuers who hope to go public. The growth and efficacy of these bankers, however, have been limited by the lack of secondary markets for securities sold via the Internet. Similarly, the lack of such secondary markets has resulted in a limited demand for directly offered shares. Unlisted, illiquid shares are simply not attractive to investors.
Investment bankers increase the potential market for an issuance by performing due diligence investigations concerning the offering and the issuer. This reduces the potential for fraud, thus reducing the risk to potential investors and thereby increasing the number of potential stock purchasers. Although new investment bankers such as IPONet require third-party due diligence checks for companies offering securities on its Web site, established bankers offer a degree of legitimacy and cachet that new Internet bankers have yet to develop.
Investment bankers also reduce risk by helping to price new offerings. As independent entities, their pricing may be less arbitrary than that used in direct public offerings, which is set by the company selling the shares.
Internet issuers have tended to be very small in terms of revenue. Consequently, the amount of capital they have been able to raise has not been significant enough for them to be financially attractive to established investment bankers, who typically won't consider representing a company with less than $15 million to $20 million in annual revenues. Their size, which typically makes them more speculative than larger companies, may deter established bankers from risking their reputations on arguably riskier investments. Finally, the limited potential for offering aftermarket support services to a company trading in an illiquid market may further deter established bankers from pursuing Internet issuers as clients.
The lack of visibility and secondary markets for Internet offerings, the arbitrary pricing, the disinterest of established investment bankers--each of these contribute to make the potential of the Internet for capital formation underexploited. But the existing regulatory structure also has not fostered offerings on the Internet .¤
Ms. Rickard is of counsel to the Washington, D.C., office of Houston's Vinson & Elkins L.L.P. Mr. Kershenbaum is an associate at Hartford, Conn.'s Day, Berry & Howard L.L.P.Home