The Convergence of Securities Law and the Internet

This article originally appeared in the Bar Journal in January 1997.

One can’t help but notice the extent to which the Internet has begun to affect our lives, business, and the law. Everything from sports and news, to business and commerce can be found on-line. These technological advancements have also begun to affect the financial and securities industry. For example, in recent years, securities news groups have flourished. These news groups consist of people who communicate on various subjects through electronic mail. While the information transmitted varies in credibility, the groups continue to grow at a rapid pace.

In addition, many financial and securities-related on-line sites have emerged. These sites are locations on the Internet where individuals and businesses can place information for others to view. You can find everything from information on companies and recent Wall Street figures, to various levels of investment advice. Many of these locations are put on-line by individuals. However, a number of reputable securities firms have begun to offer research and trading as well.

With these new opportunities to distribute information, it didn’t take long for small companies to realize that the Internet may provide a tool in obtaining financing. Small companies, unable to attract a traditional underwriting firm, have few opportunities to raise capital. Often, they find that their only means of obtaining needed financing is from friends, family, or small offerings to a limited number of people. The Internet may provide the medium small businesses need since it furnishes an opportunity to reach millions of people at practically no cost.

Early Electronic Securities Activities
In early 1995, the first securities offerings were advertised on-line by a few small companies. These businesses used the Internet to reach potential investors around the world. In addition, many of these businesses offered the delivery of their prospectus electronically. This is particularly cost effective because it allows a prospective investor to view the prospectus on-line, and then download or print it at no cost to the issuing company. These initial on-line offerings met with various degrees of success. However, regardless of their results, the potential was obvious.

It isn’t hard to imagine that these electronic securities activities were beginning to receive attention at the Securities and Exchange Commission (SEC). The 1933 and 1934 Securities Acts broadly govern the advertisement, sale, and distribution of securities1. While the SEC has been open to the use of new technologies in the past, their use generally requires extensive SEC examination2. Additionally, most approved electronic systems operate through regulated entities such as a broker-dealer. In the case of many of the early internet offerings, however, the companies did not have SEC approval, and in most instances, a regulate entity was not involved.

To deal with these uncharted waters, the SEC, in October 1995, distributed an official Release (“October Release”), that provided much of the needed framework for the electronic distribution of securities information3. This release superseded a February 1995, interpretive letter4, and provided procedures and rules for issuing companies to comply with as they explored the Internet’s potential.

Specifically, the October Release furnished rules for when the electronic delivery of information provides sufficient notice to investors, now an investor can be provided with access to information, and what constitutes evidence that electronic delivery has been achieved. The October Release also provided numerous examples to further illuminate the new rules regarding these activities. The examples cover a multitude of issues that are likely to arise with both registered and non-registered offerings. They also deal with such topics as proxy delivery and mutual fund activity on the Internet.

While further guidance will undoubtedly be necessary, the October release is comprehensive enough to help with many of the issues which arise in this area. However, perhaps more important than the actual guidance provided, was the message the October Release sent: the SEC was going to remain open-minded in the face of these emerging technologies. To that end, the Release stated that the SEC realizes that emerging technologies provide many benefits and that these benefits can now be extended to small companies and investors through the internet.

On-line Trading of Small company Stock Emerges
While the issues associated with on-line information delivery were being examined, a number of people were exploring the idea of providing liquidity to investors in small companies through the use of the Internet. Often, small companies find it difficult to complete offerings since their stock is not listed on a securities exchange. Most investors are simply unwilling to risk their capital without a secondary market for the stock. Since on-line communications provides a mechanism to reach millions of potential investors at practically no cost, it was though that perhaps an on-line secondary market could be developed for small companies.

In March 1996, one of the companies that had successfully completed an on-line public offering, deployed such a trading mechanism. The company, Spring Street Brewing, had been founded by an ex-securities lawyer who knew that the success of the company’s future offerings depended on the level of liquidity in the stock. Therefore, the Brewery sought to develop an Internet site to provide its shareholders with this liquidity.

Individuals would post their indications of interest to buy or sell the stock on the brewery’s Internet site. If someone found a trade that they were interested in they simply contacted the individual at the phone number or electronic mail address which was posted. The parties negotiated the transaction themselves, and completed a sales agreement to be sent to the company. The brewery then completed the trade, by exchanging the stock for the funds received.

Not surprisingly, when the trading mechanism came on-line it received a great deal of attention. However, in a matter of days the SEC asked the brewery to suspend its system until they could study it more closely5. Undoubtedly, many though that the SEC;s intervention spelled the end of the Internet trading for small companies. However, only five days later, the SEC indicated through an interpretive letter (“Spring Street Letter”) that they would consider approving the system if certain changes were made6. The most substantial modification necessary was the use of an independent third-party broker or escrow agent to handle investors’ funds and securities. Other requirements included providing information on the risks and lack of liquidity in the stock, recent transaction history information, and notification that any users who simultaneously posted offers to buy and sell may be considered a dealer under the federal securities laws.

Despite the changes required, the letter underscored the SEC’s commitment to working through the multitude of issues presented by electronic securities activities. It also brought a tremendous amount of attention to this emerging area or the securities industry. Spring Street Brewing received so much attention that the founder formed a separate company, applied for broker-dealer registration, and like a number of new firms, began providing consulting to businesses regarding the use of the Internet to obtain financing7. A cottage industry was emerging.

Recent Developments
Since issuing the Spring Street letter, the SEC has made a number of efforts to resolve some of the perplexing issues which face this new area of securities law. In June 1996, the SEC issues a no-action letter to Real Goods Trading Corporation (“Real Goods letter”)8. Real Goods Trading, like Spring Street Brewing, sought to establish an on-line trading system for its shareholders. The Real Goods letter approved the use of the proposed trading mechanism.

Despite the novelty of the Real Goods letter, it provides little guidance to the average small business. Since the company which sought the letter is already listed on the pacific Stock Exchange, it doesn’t represent most small businesses. Therefore, many of the disclosure and liquidity issues associated with small companies that are not listed on a traditional securities exchange are not present with the Real Good system. In addition, the system actually deployed by the company is fairly simple. It doesn’t provide recent trading information, or any assistance for investors wishing to complete a trade. Therefore, it is doubtful that the trading mechanism offers much indication of what can be expected from this new field in the future.

More recently, the SEC provided guidance in the area of on-line securities offerings. In July 1996, IPOnet, a Texas company that designed a system to place offerings by other companies on the Internet, received a favorable no-action letter (“IPOnet letter”)9. The SEC’s response to is important because it allowed IPOnet to place pubic, as well as private, offerings on-lin. While it may seem odd to envision “private” offerings on a public forum such as the Internet, the system met with SEC approval since it places the issuing company’s information behind a password-protected site. All of the viewers must be registered an evaluated with respect to their investing status prior to receiving a password and viewing private offering information.

The IPOnet letter represents the SEC’s first effort to establish guidelines for third-parties to help companies take advantage of the capital opportunities available on-line. Since the letter is a milestone in this emerging field, it is important to note a few key points. First, IPOnet is affiliated with a registered broker-dealer. The IPOnet Letter is written in such a manner that the broker-dealer is liable for the accuracy of offering information placed on-line.

Second, under the IPOnet letter any placement of offerings on-line has to be approved by the National Association of Securities Dealers, which regulated securities broker-dealers. Therefore, the letter underscores the need to involve traditional securities entities in these activities.

Finally, the IPOnet letter indicates that investors are only eligible to participate in offerings that are placed on the IPOnet system after the investor’s registration with IPOnet. Therefore, they cannot participate in offerings that came on-line before their registration. Regardless of the limitations, the IPOnet letter provides some structure for on-line offerings.

Pitfalls and Efforts to Resolve Them.
Although the SEC has made efforts to resolve some of the issues associated with on-line securities activity, many questions remain unanswered. These issues will require a great deal of attention before a set of rules and regulations can be established. Perhaps, the first topic which must be examined is the securities fraud and manipulation possible with these electronic mediums. The characteristics of the Internet are such that it would be nearly impossible to effectively regulate securities information before it is placed on-line. Any policing activities will probably require enforcement only after an infraction has occurred. This brings to mind an interesting problem which faced the SEC: who will regulate on-line trading? The SEC likely does not have the resources to handle the task.

The addition to the Structural problems associated with regulating the Internet, many of the current securities laws are not suited to cope with the technologies available in today’s world. The 1933 and 1934 Securities Acts didn’t contemplate trading markets other that the traditional systems10. Moreover, the traditional markets are, to some extent, self regulating. Therefore, the organizations which control them provide much of the structure necessary for an efficient and legal system. This leaves the SEC with a daunting task to undertake as they learn to work with this technology, and change the laws to accommodate it.

Finally, the individual states will have to make important decisions in this area. Since the Internet has no geographic bounds, information placed on-line potentially reaches individuals in every state. A number of states have begun to announce their policies with regard to these activities. Some have taken the position that registration of the securities in their state is not necessary of the offer clearly indicates that it is not being directed of offered to individuals in that state11. While this policy certainly helps small companies, many states have not adopted such a position. Without state approval, on-line securities activities will continue to be hampered, regardless of the SEC’s position. Therefore, to some extent, the individual states may hold the key to whether this technology is used by small companies to obtain capital financing.

As can be seen, a number of important issues remain to be resolved before we witness a high degree of integration between the securities industry and on-line technologies. Owner, the SEC has demonstrated a commitment to helping in the development of this new medium in a manner which benefits small companies. To this end, the SEC recently held its Annual Government-Business Forum on Small Business Capital Formation. During this forum the use of the Internet in securities transactions was a topic which received a great deal of attention. Many of the perplexing issues facing the SEC and the states were discussed in detail. IN particular, small company disclosures requirements, broker-dealer and other third-party intermediary rules, and state uniformity received a great deal of debate.

In addition to analyzing regulatory changes which need to occur, the SEC has taken a number of steps to prevent fraud and other illegal activities on-line. In a number of instances the SEC has taken action against fraudulent securities activities on the Internet12. Additionally, in July 1996, the SEC began accepting complaints by investors on-line13
. Now anyone who has access to the Internet can file a complaint with the SEC by going to their Internet address at http://www.sec.gov. The SEC also recently began distributing a flyer which provides investors with information on how to avoid securities fraud on-line. From the SEC’s proactive steps, it is clear that they intend to help make on-line securities activities beneficial to small companies, as well as prevent a proliferation of electronic securities fraud.

Conclusion
While certain aspects of the Internet will undoubtedly prove to be more hype than substance, on-line commerce and finance is likely to continue to become a way of life. It seems fairly certain that over the next five to ten years the Internet will become a valuable new tool for small companies seeking to raise capital financing. If the regulatory hurdles can be overcome, and technology continues to develop, one day on-line offerings and trading will undoubtedly become an efficient reality for small businesses.

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1. Securities Act of 1933, as amended, 15. U.S.C.; Securities Act of 1934, as amended, 15 U.S.C.
2. Delta Government Options, SEC Exch. Act Rel. No 27611 (Jan. 12, 1990); The Lattice Network, SEC no-action letter (Sept. 9, 1993); LIMITrader, SEC no-action letter (Oct. 1, 1991).
3. SEC Release No. 33-7233 (Oct. 6, 1995)
4. Brown & Wood, SEC interpretive letter (Feb. 17, 1995)
5. Wall St. J. (Mar. 26, 1996)
6. Spring Street Brewing, SEC no-action letter (Mar. 22, 1996)
7. Digital Trading on Tap, Wallstreet & Technology.
8. Real Goods Trading Corporation, SEC no-action letter (Jun. 24, 1996)
9. IPOnet, SEC no-action letter (Jul. 26, 1996)
10. Securities Act of 1933, as amended, 15 U.S.C.; Securities Act of 1934, as amended, 15 U.S.C.
11. Pennsylvania (CCH Blue Sky Reports 48,684, Sept. 1, 1995)
12. SEC v. Sellin, DC SFla, Case No. 96-6825-CIV-Ungaro (Jul. 25, 1996).
13. Interactive Financial Services (Aug. 15, 1996)

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