Introduction

E-Commerce is beginning to live up to the hype.  Companies are selling books,[1] cars,[2] prescription drugs,[3] toys[4] and just about any other item you can imagine.[5] Companies have even started selling themselves.[6]  Internet direct public offerings (IDPO) are becoming a common way for smaller companies to raise much needed capital, while giving small investors an opportunity to “get in on the ground floor.”

 

This paper examines the impact of the Internet on capital markets for small companies.  First I analyze the federal and state securities regulations concerning small company IDPOs.  Next, I review electronic document delivery and its impact of IDPOs.  Finally, I look at the secondary trading market for IDPO stocks.

 

Regulating Securities

Early on, the federal government left securities regulation to the states.[7]  However, the stock market crash of 1929, and the Great Depression that followed, precipitated federal action.[8]  Although the federal government enacted securities regulations, the states never abandoned regulating securities.[9]  Since federal intervention “the federal government and the states have jointly regulated securities offerings.”[10]

 

Federal Securities Regulations

Shortly after the ’29 crash, Congress enacted the Securities Act of 1933 (Securities Act), designed to protect investors from unscrupulous issuers, brokers and dealers.[11]  In broad terms, the Securities Act required issuing companies to register each offering with a federal agency; provide a prospectus that fully disclosed all material facts to each purchaser; and, limited communications surrounding the offer.[12]

 

The next year, Congress enacted the Exchange Act of 1934 (Exchange Act).[13]  Among other provisions, the Exchange Act created the Securities and Exchange Commission (SEC); required publicly held companies to make continuous periodic disclosures about their business finances, operations and management; and, regulated securities exchanges.[14]  Through 1940, Congress enacted several additional regulations effecting the securities industry.[15]

 

Federal Securities Regulation Exemptions

The basic registration under the Securities Act, available to all companies, is accomplished with Form S-1.[16]  Under Form S-1 detailed information is required about every aspect of the issuer and the offering.[17]  Several alternative forms are available for small companies, Forms SB-1 (for issues up to $10 million in a twelve (12) month period) and SB-2 (allows unlimited dollar amount).[18]  However, each requires audited financial statements and continuous disclosure under the Exchange Act.[19]

 

To justify the costs and burdens imposed by the basic registration process, only large offerings are economically feasible.[20]  Large offerings also require additional costs.[21]  Venture capitalists are needed to finance accountants, attorneys and registration fees; underwriters are needed to perform a due diligence investigation of the company, thereby insuring reliability of the offering to investors and creating a secondary market; and brokers and dealers are needed to market the shares to investors.[22]  The SEC relies on this layered approach to protect investors against fraud.[23] 

 

The process, as described, is inherently prohibitive to small companies with new, innovative ideas.[24]  Over the years, exemptions to the Securities Act have been created.[25]  For example, the Securities Act exempts from registration private placements,[26] sales to employee benefit funds,[27] intrastate offerings,[28] sales to accredited investors[29] and some small business offerings.[30]

 

The two most important exemptions for IDPOs are Regulation A and Rule 504 under Regulation D.  Rule 504 offerings are sometimes referred to as SCOR offerings (named after the Small Corporate Offering Registration form used to register offerings in many states).[31] 

 

The choice depends on the size of the offering.  Under each regulation, the securities may remain freely tradable and available to all investors, not just “accredited investors.” [32]  I will review reach regulation separately.

 

Regulation A

The SEC created Regulation A under authority of Section 3(b) of the Securities Act. [33]  Regulation A offerings are exempt from full registration, but still require a limited registration statement with the SEC for review. [34]  The registration statement consists “of a notification, offering circular, and exhibits.” [35]  In addition, the public offering must not exceed “$5 million in any 12 month period.” [36]  Other benefits of Regulation A over a full registered offering are examined next.

 

(a)   Financial Statements

 Basic registration under Form S-1 requires a financial statement that meets strict SEC rules. [37]  In addition, the financial statement must be audited by an independent certified public accountant. [38]  Forms SB-1 and SB-2 also require audited financial statements. [39] 

 

Financial statements under Regulation A need not meet the strict SEC requirements. [40]  Rather, generally accepted accounting principles apply. [41]  Also, the financial statements do not have to be reviewed by an independent auditor. [42]

 

(b)   Exchange Act Reporting

Publicly held companies that register offerings are required to file reports with the SEC for the first fiscal year in which the registration is effective. [43]  In addition, a public company must continue to make periodic statements under the Exchange Act if the offering is registered under the S-1, SB-1 or SB-2 forms. [44]  The reporting statements provide information about the companies:

 

·        operations;

·        officers, directors, and certain shareholders (including salary, various fringe benefits, and transactions between the company and management);

 

·        financial condition (including financial statements audited by an independent certified public accountant); and

 

·        competitive position and material terms of contracts or lease agreements.[45]

 

 

In contrast, a company that submits a limited registration under Regulation A is not obligated to report under the Exchange Act unless the company has more than $10 million in total assets and more than 500 shareholders. [46]

 

(c) Prospectus Requirement

The Securities Act also requires a full prospectus be delivered to every purchaser. [47]  A full prospectus contains much of the information contained in the full registration statement regarding the companies business, the property it owns, competition, a list of managers and officers, pending and potential legal proceedings, and the intended use of the proceeds of the offering. [48]

 

A Regulation A offering allows the issuer a choice of three (3) prospectus formats. [49]  An issuer may offer a full prospectus, an offering circular containing general information about the offering, or an offering circular in a question and answer format. [50]

 

(d) Test the Waters

Companies registering under the S-1, SB-1 and SB-2 are strictly forbidden from “shopping the offer” to anyone before the SEC approves the registration. [51]

 

 Under Regulation A, issuers can solicit potential purchasers about a contemplated offer, before they incur the expense of registering. [52]  Under the “test the waters” provision an issuer may determine if there is interest in the proposed offering by advertising on television, radio or the Internet. [53]  The issuer may also advertise in magazines, newspapers and direct mail. [54]  However, the issuer must not solicit or accept money before the SEC completes its review of the offering and the issuing company delivers the offering circular to investors. [55] 

 

If the company determines there is adequate interest, the company may file a full registration report, file a registration under Regulation A, file a U-7 form under Rule 504 of Regulation D, opt for a private placement, or abandon its plan of offering securities. [56]

 

The “test the waters” provision is a powerful provision, not available under other registration schemes. [57]  It allows small companies the flexibility they need.

 

Regulation D

Securities offered under Rule 504 of Regulation D are often referred to as SCOR offerings. [58]  They take the name from the SCOR Form that was created with the Rule 504 exemption in mind. [59]  Rule 504 of Regulation D is the second important registration exemption option for small company IDPOs. After a company files a U-7 form,[60]  they may sell up to $1 million of securities in a twelve (12) month period. [61]

 

As of April 7, 1999 Rule 504 has been modified, because the SEC was concerned about fraud in the secondary markets.  Before Rule 504 was modified, every offering under the rule was freely tradable and the issuer could “engage in general solicitation or general advertising” of the offer. [62]

 

The modified rule reverts back to the “pre-1992 framework.” [63]  Under the modified rule:

 

An issuer will only be able to issue unrestricted or freely tradable securities in a Rule 504 offering and engage in general solicitation or general adverting in two circumstances:

 

·        If it registers the offering under a state law that requires the public filing and delivery of a disclosure document to investors before sale; or

 

·        If the transaction is effected under a state law exemption that permits general solicitation and general advertising so long as sales are made only to “accredited investors.” [64]

 

 

Most states require issuers to provide a disclosure document to investors. [65]  Therefore, the recent modification should not have an impact on most offerings under Rule 504. [66]  However, the SEC is monitoring Rule 504 offerings and may restrict the stock in the future.  A restricted stock may not be resold for one year after the initial purchase. [67] 

 

If the SEC imposes the restriction, it would raise the cost of issuing stock under Rule 504 substantially. [68]  First, the demand for a restricted stock is much less than a freely traded stock. [69]  Less demand means a lower price. [70]  Next, investors that did purchase the stock would demand a premium for the restriction, which would drive the price even lower. [71]

 

Blue Sky Laws

In addition to federal regulations, each state has securities regulations of its own (“Blue-Sky” [72]).[73] Under federal preemption rules, securities are exempt from state regulations if the company is subject to the Exchange Act reporting requirements and the security is listed on a national exchange, or quoted on the National Association of Securities Dealers Automated Quotation System (NASDAQ).[74] Otherwise, a state has jurisdiction over securities offered for sale, or sold, within that state.[75] 

 

In an effort to thwart federal preemption,[76] unify state laws and ease the burdens on small companies, three important measures have been enacted in most states: (a) The Internet Resolution; [77] (b) The Small Corporation Offering Registration; [78] and, (c) The Regional Reporting Program. [79]  Each measure is discussed separately.

 

(a)   The Internet Resolution:

For IDPOs, the Blue-Sky laws present an interesting problem.  Because the Internet is a world wide computer network, available to citizens of every state, every state could require the issuer of an IDPO to register, or obtain an exemption, in their state. [80] 

 

In 1995 the Pennsylvania Securities Commission enacted an order concerning Internet offerings. [81]  The order made Internet offerings exempt from state registration if two conditions were met. [82]  First, the offer must have indicated, directly or indirectly, that the securities were not being offered to persons in Pennsylvania. [83]  Second, no sales of the issuer's securities were made in Pennsylvania as a result of the Internet offer. [84]

 

Since Pennsylvania enacted the order, the North American Securities Administration Association (NASAA) encouraged other states to enact a similar policy. [85]  Known as the NASAA Internet Resolution, thirty-two (32) states have adopted the resolution and fifteen (15) additional states have indicated that they too will adopt the resolution.[86]

 

(b)   The Small Corporate Offering Registration :

The Small Business Investment Incentive Act of 1980 (Small Business Act) left regulation of offers under $1 million to the states. [87]  In response to the Small Business Act, the State of Washington developed a program to simplify the registration process for small companies. [88]  “The aim of the program was to streamline the application, information disclosure, and prospectus process into a single document.” [89] 

 

In 1989, using the Washington State program as a model, NASAA developed the Small Corporation Offering Registration (SCOR) form. [90]  “The SCOR form is a simplified question and answer format used for the registration of securities offerings with approximately 47 states.” [91]  The form lists some fifty questions. [92]  In most states that use the SCOR form, an issuer may also use the SCOR form as a disclosure statement to investors. [93]

 

(c)   The Regional Review Program:

To make the registration process less burdensome, many states have enacted a Regional Review Program (RRP). [94]  There are currently three RRPs, [95] and a fourth RRP[96] is scheduled to begin in the spring of this year (1999).  In all, twenty-eight states will have enacted the program. [97] 

 

Under an RRP, an application is simultaneously submitted to each member state. [98]  The participating states select one state to review an offering registration, and comment on it. [99]  If the selected state clears the application, each of the states in the region clears the application as well. [100]  The RRP greatly decreases the time it takes to register, and the legal fees necessary to submit an application.[101]

 

Electronic Delivery

Spring Street Brewery, Inc. is a microbrewery located in the state of New York. [102]  In 1995 the three-year-old brewery was in need of capital to expand operations. [103]  Because Spring Street was a young company with modest sales, the traditional venture capitalist – investment banker – broker route was not an option. [104]  Instead, Andrew Klein, Spring Street’s CEO, pioneered the IDPO. [105]

 

Mr. Klein is a former New York securities lawyer, so dealing with state regulators and the SEC was nothing new to him. [106]  Spring Street issued 900,000 shares at $1.85 per share under Regulation A.[107] The offering went on sale March 1, 1996, and, in several months, Spring Street raised $1.6 million by selling 864,000 shares to 3500 investors. [108]

 

Spring Street was not the first company to go public under Regulation A.  What made the offering novel was that, for the first time, an electronic prospectus was made available to prospective investors of a Direct Public Offering on a web site.[109]

 

EDGAR

The SEC recognized the benefits of electronic document delivery early on. [110]  In 1984 the agency began a pilot program that allowed about 500 volunteer companies to forego paper disclosure documents and submit their SEC filings via computer. [111]  By 1993 the agency began  “collecti[ng], validati[ng], indexing, accept[ing], and forwarding submissions by [all] companies and others who are required by law to file forms with the U.S. Securities and Exchange Commission.” [112]  

 

The system is known as the Electronic Data Gathering, Analysis, and Retrieval system, or EDGAR. [113]  EDGAR’s “purpose is to increase the efficiency and fairness of the securities market for the benefit of investors, corporations, and the economy by accelerating the receipt, acceptance, dissemination, and analysis of time-sensitive corporate information filed with the agency.” [114]  The EDGAR system became available via the Internet, free of charge, in September 1995. [115]

 

Electronic Prospectus

With the SEC’s experience with the EDGAR system, its position on electronic delivery of prospectuses, as articulated in the February 1995 Brown and Wood SEC no-action letter (Brown & Wood) is not a surprise. [116]  In that letter, the SEC ruled that “it is the [SEC]'s view that the term ‘prospectus’ as defined in Section 2(10) of the Securities Act of 1933 . . . includes a prospectus encoded in an electronic format (an ‘electronic prospectus’).” [117] 

 

The SEC issued a detailed interpretation, effective October 6, 1995, of an “electronic prospectus” which spelled out the two primary requirements: notice and access. [118]  

 

(a) Notice

In order to satisfy the notice requirement for a prospectus that is available for downloading from a web site, an issuer must have evidence of delivery. [119]  Evidence of delivery can be obtained in a number of ways. [120] For example: (1) the issuer may obtain an informed consent from the investor to deliver the prospectus electronically.  (2) The issuer may offer proof that the investor printed, downloaded, or accessed the prospectus from the web site.  (3) The investor may send a return e-mail confirmation of receipt.  (4) The investor may use forms or other materials included in the electronic prospectus.  The examples listed here are not the only ways to meet the notice requirement. [121]

 

(b) Access

Regardless of the availability of an electronic prospectus, a paper prospectus must be available to every investor. [122]  This requirement is a precautionary measure, in case of an electronic breakdown. [123]  However, an investor may request a paper prospectus for any reason.[124] 

 

The electronic prospectus must also be readily accessible. [125]  If the prospectus is available on the issuers web site, it may not be too “deep” into the site. [126]  For example, if the document can only be reached through a series of complicated menus, the document may be deemed “inaccessible” and fail the access requirement. [127]

 

Benefits of an Electronic Prospectus

There are advantages to electronic prospectuses over paper versions.  First, and the most appealing to small companies, is the lower costs associated with an electronic prospectus. [128]  A paper prospectus “can cost as much as $ 6 to print and mail -- the old-fashioned way -- each prospectus to potential DPO investors.  But with a[n] [electronic prospectus], the whole prospectus cost is less than $ 5,000.” [129] 

 

Another benefit of electronic prospectuses is the additional information that can be supplied through hyperlinks within the document. [130]  A prospective investor can “click” on a link to learn about the company’s plans from the CEO of the company through a multimedia presentation, about the company’s latest product line from a recent news article, or a whole host of additional information from a variety of sources.

 

In addition to containing more information, an electronic prospectus is easier for a potential investor to read.  The table of contents can also provide links to pertinent information within the document itself.  Or a search of words or phrases can be executed, bringing the potential investor to the information he / she think is important, without having to sift through information he / she deem irrelevant to his / her investment decision.

 

Marketing exposure is another benefit of electronic prospectuses.[131]  Once a prospectus is made available on-line, any one can download the prospectus, twenty-four (24) hours a day.[132]  In addition, a host of companies have formed to provide delivery services of an IDPO electronic prospectus.[133]  Potential investors from around the country, and around the world, frequent the sites in search of investment opportunities.[134]  If an investor becomes interested, they can download a prospectus, research the company, its competitors and its industry on-line, and make an informed investment decision.

 

Yet another benefit of an electronic prospectus over its paper counter-part is the competitive advantage on-line investors have over traditional methods.[135]  The faster an investor can obtain pertinent information, the faster the investor can act on it.  If a traditional investor must wait for the postal service to deliver his prospectus, that investor must also wait to invest, thereby missing an opportunity.  

 

Direct Public Offerings (DPO) have been around a long time.[136]  Before the Internet, companies focused their marketing efforts to existing customers.[137]  To reach investors a company would include a notice of an offering on the label, [138] or within the box of its product.[139]  An electronic prospectus not only markets the IDPO to investors who may not be familiar with the company; it may also help sell the issuer’s product or service, because investors in a company can make good customers as well. [140] 

 

Secondary Markets

The lingering problem with DPOs, and a substantial risk to investors, is the lack of liquidity of the shares. [141]  While Regulation A and Rule 504 offerings are unrestricted, if there is not an active secondary market in which investors can sell their stock, the benefit or a “freely tradable” stock is meaningless.

 

Issuer-Based Bulletin Boards

Mr. Klein of Spring Street had a solution for the liquidity problem too. [142]  Spring Street set up a trading site named after one of its best selling beers, Wit. [143]  Wit-Trade began a bulletin board trading system that connected investors that wanted to purchase shares of Spring Street to sellers of Spring Street stock. [144]  Although, shortly after trading began, Spring Street voluntarily halted trading while waiting for approval of the SEC. [145] 

 

That approval came in an April 17, 1996 SEC no-action letter. [146]  In that letter, the SEC “recognize[d] Wit-Trade [a]s an innovative mechanism that has the potential to provide Company shareholders with greater liquidity in their investments.” [147]   The SEC “encourage[d] such modernization, but it is [their] job, first and foremost, to insure protections for public investors.” [148] 

 

With investor protection in mind, the SEC spelled out the procedures an issuer-based bulletin board must follow in order to remain exempt from rules governing an “exchange,” “broker-dealer,” or an “Alternative Trading System” in several SEC no-action letters. [149] The issuer may not:

 

i)                  receive any compensation for creating or maintaining the System;

 

ii)                receive any compensation for the use of the System;

 

iii)             be involved in any purchase or sale negotiations arising from the System;

 

iv)              give advice regarding the merits or shortcomings of any particular trade;

 

v)                use the System directly or indirectly, to offer to buy or sell securities, except in compliance with the securities laws, including any applicable registration requirements (absent an available exemption therefrom); or

 

vi)              receive, transfer or hold funds or securities as an incident of operating the System. [150]

 

 

For example, an issuer may set up a site with a “passive” bulletin board. [151]  A passive bulletin broad may “provide the names and addresses of prospective buyers and sellers and the price at which they are willing to buy or sell.” [152]  Then the participants contact each other and the trade is “executed outside the system.” [153]

 

Connecting buyers and sellers of an issuers stock in one centralized, accessible location goes a long way to providing an active secondary market. [154]

 

Alternative Trading Systems

Third party bulletin boards are also available to trade a small company’s Regulation A or Rule 504 shares. [155]  For example, Direct Stock Market, Inc., [156] and Elysian Group, Inc. [157] each offer a “web-based, on-line stock listing system” so buyers and sellers of a company’s stock can trade shares. [158]

 

In addition to the obstacles created by the Securities Act, the Exchange Act, and other federal regulations, small companies face additional obstacles.  They have difficulty reaching potential investors, providing company specific information and, convincing them to invest in stocks without a ready secondary market.

 

Listed Exchanges

Recently, the Pacific Stock Exchange started listing some Rule 504 of Regulation D (SCOR) and Regulation A companies on their exchange for active trading.[159]  While most small companies do not meet the criteria necessary to be listed, the requirements are far less than a NASDAQ listing.[160]

 

Conclusion

 

The Internet has opened up capital markets to small companies.  For a company to benefit from an IDPO, its managers and officers need to understand the types of offerings available, and how to implement them.[161]  State and Federal regulators have made many changes to accommodate and encourage IDPOs.  However, it is my position that they have done too little, too slowly.  Rather than tinkering with the existing regulations that were designed for yesterday’s technologies and concerns, many of these regulations should be repealed.

 

First, the Securities Act should be repealed, not just amended.  If the purpose of the act is to mandate disclosures to protect investors from fraud, than the Exchange Act requirements satisfy that purpose.  Every issuer must file a disclosure under the Exchange Act for at least the first year of the offer.  The information that is required of a Regulation A or Rule 504 under Regulation D Exchange Act disclosure mirrors the information required under the Securities Act. 

 

In addition, because the EDGAR system database has the disclosures on file, free for anyone to gather, if a stock is available for sale the investor is on “notice” that the they have “access” to prospectus type information. [162]  The only SEC requirement for delivering electronic prospectuses not met, is the availability of a prospectus in paper form for investors that do not have access to the Internet.  That requirement can be met by mandating an issuer to mail or fax a copy of the Exchange Act disclosure statement to anyone that requests it, under the Exchange Act.

 

Next, blue-sky laws have to go.  In an era when small companies were local, or, at most, regional, blue-sky laws caused little harm.  In fact, they may have been beneficial, to the extent they freed small companies from unnecessary federal regulations.  Because small companies operated locally, there was little chance of selling shares of their company across the nation.  However, in today’s world, small companies can operate globally.

 

If investors are protected from fraud under the federal regulations, the only remaining reason to maintain state regulations is to continue the revenue flow. If companies are not required to register in a state, they do not pay filing fees in that state. 

 

Most states have implemented the Internet Resolution, as discussed above.  The Internet Resolution only requires companies that sell stock within the state to register in that state.  Taxing the issuing company on sales within the state could generate the same revenue, perhaps a greater amount.  In that way, a company would save on attorney and filing fees, and only pay on the stocks actually sold. The fact that some states have refused to implement the resolution only supports the need for federal preemption.

 

Finally, Alternate Trading Systems need to be encouraged.  If investors have necessary information available at will, they can make informed decisions.  While it is true that small company IDPOs are risky securities, limiting the secondary market for these stocks only increases the risk.

 

Alternative Trading Systems may make it possible for smaller companies to step up from a issuer-based bulletin board, to an Alternative Trading System, to the Pacific Stock exchange to a NASDAQ listing.  The possibility of such a progression will help to make a small company’s stock offering successful, therefore, the difference between success and bankruptcy.

 

The growth of the Internet since the first IDPO has been staggering.  Federal and State regulators must realize that the train has left the station, and they should get out of the way.