West Orange, New Jersey


1996 A. Jared Silverman. All rights reserved.


With the increasing use of cyberspace for commercial transactions, entrepreneurs and others are sta rting to look at this new communications medium as a mode of capital formation. With its ability to span the globe and its denizens with desirable demographics, cyberspace will be a cost-effective forum for raising capital.

Dual federal and state jurisdiction over securities posses multiple compliance problems in the United States. The global nature of the Internet creates new compliance problems because of the accessibility anywhere in the world of Internet documents related to capital formation.

Whether a posting of an offering on the Net would pass regulatory muster depends on a number of factors:

The Reach of Cyberspace

Cyberspace is an ideal medium for capital formation because of its global reach and its relatively inexpensive way of reaching a large number of people. According to a recent Dun & Bradstreet Nielsen Media Research survey, in the United States and Canada alone, 17.6 million people use the World Wide Web and nearly 37 million have access to the Internet. Of this group, about 2.5 million have purchased goods and services over the Web. These people have desirable demographics. /they tend to be up-scale, educated professionals with household income in excess of $80,000.

Recognizing the potential of cyberspace in the capital formation process, the Securities and Exchange Commission in Release No. 33-7233, dated October 6, 1995, issued guidelines, discussed more fully below, regarding the use of electronic media for information delivery. Among the reasons given for the release was that the use of electronic media enhances the efficiency of the securities markets, allowing rapid dissemination of information to investors and the financial markets in a more cost-effective, widespread and equitable manner than traditional, paper-based methods.

Who Has Jurisdiction?

One of the first questions to be asked when dealing with transactions in cyberspace is who, if anyone, has jurisdiction of the transaction? That is not an easy question to answer because of the global nature of the Net. In the United States, we are used to dealing with the dual jurisdiction of federal and state laws over securities matters. Now there is the possibility of a foreign government agency claiming jurisdiction over what would normally be considered a United States matter or a state securities agency exerting jurisdiction over what a foreign government would consider a purely domestic matter.

In the global environment of the Net, each jurisdiction in which an offering is accessible over the Net will have its own definitions of a security, an exempted transaction, an offer, a regulated transaction and a regulated person. Issuers of securities, parties attempting to raise capital on behalf of issuers, such as underwriters and investment bankers, entrepreneurs and others using cyberspace to raise capital should be aware that their requests for capital may subject them personally, their postings to cyberspace, their instruments of capital formation and their transactions related to capital formation to the statutes and regulations of many jurisdictions in which their postings may be downloaded.

Suffice to say that a securities regulator that feels that there has been the necessary contacts with its jurisdiction can, and will, enforce its statutes, even in cyberspace where in personam jurisdiction may be difficult to obtain, as may enforcement of the regulator’s orders. Nevertheless, the New Jersey Bureau of Securities and the SEC each have moved against unregistered offerings posted in cyberspace.

Consider the following two hypothetical cases. First, a request for investors in a film partnership is posted by the partnership in Sydney and downloaded by a potential investor in New Jersey. Second, an offering statement is available at the issuer’s Web site on a listserver in New York and is read in Ottawa, Ontario, Canada (there is no federal regulation of securities in Canada, but province-by-province regulation), by a potential investor who requests additional information by e-mail.

Keep these hypotheticals in mind during the subsequent discussion that concentrates on conventional securities regulatory analysis in the United States extended into cyberspace. However, any of the practice problems described will be mirrored globally.

Is It A Security?

As with all matters relating to capital formation, the first question to ask is whether there is a "security" as defined by either the Securities Act of 1933 or by the relevant state securities law. (The state laws are called "Blue Sky Laws." For the purposes of this article, the Uniform Securities Act that has been adopted in various forms by a majority of the states will be used for reference.) The definition of "security" is a broad one and should be checked to see if the method of financing is covered.

The most problematic portion of the definition of security is that of the investment contract. Under the modified Howey test, S.E.C. v. W.J. Howey Co., 328 U.S. 296 (1946), an investment contract constituting a security is one where there is (1) an investment; (2) in a common enterprise; (3) with the intent to make a profit; (4) relying substantially on the efforts of a third party. Among the "investment opportunities" that have qualified as securities under this test have been orange groves, Ponzi and pyramid schemes and eel farms on the Net, among others, as offerors of unregistered securities.

Even if the instrument is a security, it may be exempt from registration under the 1933 Act and/or the Uniform Securities Act. Care should be taken to make sure that the exemption is unavailable federally and in all states.

One such exemption is the exemption for securities issued by a state or its political subdivisions, such as municipal bonds. (Remember, exemption from registration does not exempt the security from the fraud jurisdiction of securities regulators.) On July 14, 1995, a preliminary offering statement of a $6.9 million bond issue for the Village of Northbrook, Ill., was posted on the Internet at the underwriter’s Web site. Such an offering on the Net is beyond the registration jurisdiction of the SEC and states just as it is in the "physical" world.

The Pennsylvania Securities Commission in August 1995 issued an order providing an exemption from registration for all offers made on the Net that comply with certain conditions. The order exempts the offer of securities by an issuer that does not seek to sell its securities in the state. It does not exempt the sale of the securities from jurisdiction, nor does it exempt the offer or sale from the Commission’s antifraud jurisdiction. To avail itself of the sale harbor, the issuer must indicate directly or indirectly that no sale of securities is intended in Pennsylvania.

The Pennsylvania order was first order of a securities regulator that specifically addressed offers in cyberspace. Recently, the North American Securities Administration Association, the association of United States state and Canadian provincial securities regulators, and the Mexican securities agency, adopted the recommendation of its Internet Committee that all member jurisdiction utilize the Pennsylvania approach. To date, Alaska, Illinois, North Dakota, Texas and Vermont have an Internet "exemption" similar to Pennsylvania.

Is There An Offer?

The 1933 Act and the Uniform Securities Act not only regulate sales and purchases, but also offers to sell and offers. The wording of 2(3) of the 1933 Act and 401(j)(2) of the Uniform Securities Act (1956) defining "offer to sell," "offer for sale" or "offer" is virtually identical and includes "every attempt to offer to dispose of, or solicitation of an offer to by, a security or interest in a security for money." Regulators and courts have construed the term "offer" liberally.

Section 5 of the 1933 Act proscribes certain acts interstate commerce in terms of three periods related to the registration process. The first period is the pre-filing period. During this period, when the issuer is contemplating a public offer but has not filed a registration statement with the SEC, it is unlawful for persons, directly or indirectly, to buy, sell, or offer to buy or sell the issuer’s securities.

The second period is the waiting period. During this period, when the registration statement has been filed with the SEC but before it has been declared effective and sales pursuant to the statement may commence, actual sales are not permitted but the market may be conditioned and potential buyers may be solicited with others. Offers to sell must be made in the manner prescribed by the SEC.

The third period is the post-effective period after the registration statement has been declared effective and actual sales may commence. Purchasers of the registered securities must receive a copy of the final prospectus.

The process under 301 of the Uniform Securities Act is simpler. It is unlawful for any person to offer or sell any security unless it is either registered or the security or transaction is exempt. A posting to the Net, especially during the pre-filing period, likely would be considered unlawful.

Exemption Under Regulation A

The 1992 modifications to Regulation A, 17 C.F.R. 230-251 et seq., commonly known as the Small Business Initiatives or SBI, may have an effect on small issuers trying to raise capital in cyberspace. Rule 251 states that a public offer or sale of securities meeting the conditions of Regulation A is exempt from the registration requirements of the 1933 Act.

One condition is the sum of all cash and other consideration to be received for the securities, the "aggregate offering price", in any continuous 12 month period not exceed $5 million, including $1.5 million offered by selling security holders. There are other conditions that will not be discussed here. Practitioners should review Regulation A to determine its applicability.

Even if the Regulation A exemption is available at the federal level, it is not available at the state level. This federal exemption should not be confused with the simplified registration statement (Form U-7) permitted in many states under the Small Corporate Offering Registration for aggregate offerings up to $1 million an any 12 month period.

Testing the Waters

Regulation A also permits pre-offering solicitations of indications of interest subject to SEC oversight. Rule 254 permits an issuer to "test the waters" by publishing or delivering to prospective purchasers a written document or by making scripted radio or television broadcasts to determine whether there is any interest in a contemplated securities offering.

The document or script must state that no money or other consideration is being solicited and will not be accepted; that no sale will be made or commitment to purchase accepted until delivery of an offering circular that includes complete information about the issuer and the offering; that an indication of interest involves no obligation or commitment of any kind; and must identify the issuer’s chief executive officer and briefly identify the issuer’s business.

A copy of the document or script, prior to the date of first use, should be filed with the SEC Regional Office for the region in which the issuer’s principal operations are conducted or proposed to be conducted. Any testing-the-waters document complying with Rule 54 may include a coupon, returnable to the issuer, indicating interest in a potential offer along with the prospective in vestor’s name, address and telephone number.

While Rule 254 might prevent problems with the SEC during the pre-filing period, the result might not be the same in the states. A majority of states do not permit testing the waters, and those that do may permit it on the same terms as the SEC. Thus, a testing-the-waters posting to the Net that complies with Rule 254 might not be acceptable under the 1933 Act, but might be actionable under the equivalent of 301 of the Uniform Securities Act in those states that do not have a comparable safe harbor and that deem there to be sufficient contact with the state to exert jurisdiction.

SEC’s Guidelines For Electronic Document Delivery

The term "electronic media" as used by the SEC in its October guidelines is broad and specifically includes audiotapes, videotapes, facsimiles, CD-ROM, electronic mail, bulletin boards, Internet Web sites and computer networks. Documents covered by the guidelines include prospectuses, documents furnished in connection with tender offers or going private transactions. Regulation A offering circulars, and Regulation D disclosure documents (with a caution against violating Rule 505 and 506 prohibitions against gender offers.)

The SEC guidelines are based on the premise that information delivery should approximate information delivery on paper. Thus, when looking at whether electronic delivery meets the legal requirements pertaining to delivery of documents, the SEC considers two factors, notice and access.

Electronic communications should provide timely and adequate notice to investors. Supplemental communications should be considered to provide notice similar to that provided by delivery on paper. An electronic document, such as e-mail, should be self-contained. If the document is on a Web site, separate notice of the existence of the document at the site would be necessary unless the issuer can otherwise evidence that delivery to the investor has been satisfied or the document is not required to be delivered under the federal securities laws.

The guidelines also state that recipients who are provided information electronically should have access comparable to that provided by postal mail. Therefore the use of electronic media should not be so burdensome that the intended recipients cannot access the information. If disclosure is made on the Internet or similar means, the document should be accessible as long as the delivery requirement applies. If an issuer posts a preliminary prospectus on its Web site, the prospectus should be updated to the same extent as paper and should be available to all prospective investors to whom the issuer intends to sell securities in reliance on the electronic delivery of the prospectus.

Finally, issuers and others using electronic delivery must have reasonable assurances that the delivery requirements have been met. Procedures involving this assurance might include obtaining the informed consent of an investor to receive the information through a particular electronic medium while assuring the access and notice requirements are met; obtaining confirmation that the investor actually received the information; disseminating information by facsimile; an investor obtaining the document through a hyperlink; and using form and other materials available only by accessing the document.

No state has issued guidelines similar to those of the SEC. Therefore, the SEC guidelines may have marginal benefit unless they are recognized by state securities regulators.

Understanding Business In Cyberspace

Spring Street Brewery, a New York microbrewery, is believed to have been the first issuer to conduct an offering on the Net. Spring Street established a home page on the Web that allowed investors using the Internet to examine and download its offering documents. Spring Street qualified as a Regulation A offering, i.e., the total amount to be raised by the offering was under $4 million and therefore exempt from registration with the SEC. However, the offering was registered in 18 states and the District of Columbia.

Spring Street demonstrates how, through the use of exemptions and registrations, an offer in cyberspace may be made. If the security is exempt under both federal and state law, like the municipal bonds of the village of Northbrook discussed earlier, no registration would be necessary.

The Spring Street offering raised $1.6 million. However, the direct offer of Spring Street stock also raised a question about its liquidity since there was no underwriter or market maker. To remedy this problem, in March 1996 Spring Street created Wit-Trade, a bulletin board system, one for buyers and one for sellers, designed to match buyers and sellers of the company’s securities. Buyers and sellers would contact each other by e-mail and document a trade on a company provided electronic contract. Payments and stock certificates were mailed to the company to complete the sales.

At the request of the SEC, Spring Street halted use of Wit-Trade pending SEC review. In a letter dated March 22, 1996, the SEC stated that Spring Street, by handling investors funds and securities, ran the risk of being a broker-dealer and, at a minimum, should use an escrow agent to handle funds.

The SEC also required the company to supplement investor information to inform them of the risks inherent in investing in illiquid securities. Additionally, investors should be informed that, if they post quotations simultaneously on both the buyers and sellers bulletin boards, they may be considered a "dealer" that is required to register and comply with federal securities laws.

A Quick Tour of Cyberspace

Cyberspace, a.k.a. the Information Infrastructure (national or global, depending on your vantage point) or Information Superhighway, is an amalgam of various on-line services. Once you have accessed cyberspace, there is a bewildering and rapidly increasing number of places you can visit.

Communications in cyberspace can be either public (but not necessarily confidential) or private. Electronic mail or e-mail is an example of private communication. E-mail can be either be one-to-one or one-to-many as in a distribution list. But in either case, the sender does not intend the communication to go beyond the designated recipients(s). On the other hand, public communications are those that the sender intends the world to see. These include one-to-many communications with the discussion areas in the commercial services, Internet FTP sites and Usenet news groups. Web site communications have two characteristics: one-to-many on the outbound side when the site owner is trying to send or provide information to the public; and many-to-one on the inbound side when the site owner receives communications from the public.

Commercial services, such as America On-line, Prodigy and CompuServe, have discussion areas, bulletin boards and forums dedicated to discussing investments and business opportunities. Additionally, they have various wire services, newspapers, magazines and databases that could be used for research, and "shopping" areas where a user can get in touch with providers of financial services and even place orders with brokerage firms. There are also public and private bulletin boards - BBSs - and list-servers that are dedicated to specific subjects.

Finally, there is the Internet, which is accessible world-wide. The Internet, or the Net, is only a portion of cyberspace. The Net is not under any form of centralized management but rather is a collection of interconnected nodes at which there are computers that store information, service information requests and set up communications links with the rest of the Net. While there are a number of services and resources available on the Net, three will be mentioned here.

First, there is the FTP -- file transfer protocol - service, which allows transferring or copying files from one computer to another. Many individuals and organizations have made information, archives and programs available to the general public through the use of anonymous FTP (no identification is necessary).

Second, there is Usenet (from "User’s Network"), a collection of discussion groups on almost every subject of interest to people, including securities and business opportunities. In essence, like these sites are BBSs run by news administrators. Some sites related to capital formation, and the subject covered, are: misc.invest - any investment related matter; misc.invest.stocks - materials related to securities; misc.invest.canada - Canadian investments; and misc.entrepreneurs - operating your own business and business opportunities.

Third is the World Wide Web, or WWW, where there are personal, educational, government and commercial home pages or Web sites. Using an architecture of inter-connected computers, it uses hypertext to link to other places in a document, or other documents at the same site, or to other sites. Web documents may contain text only, or graphics and video and sound clips.

Hypertext is the building block of home pages. A home page is a form of an address where the world can reach you on the Net. Businesses are setting up Web sites at a feverish pace. They are used to inform the public and potential customers about the business of the site owner and to conduct the business of the owner, such as accepting customer orders.

In the case of a financial services firm, a Web site can be used to supply information to the public about various securities and other financial products and services, and to accept investors’ orders. In the case of a business, a Web site can be used to disseminate financial information about the firm and to increase interest in investing the site owner.


Issuers, underwriters and broker-dealers in increasing numbers will be turning to cyberspace to assist them in the capital formation process. Issuers trying to benefit from the SEC’s small issues exemption in Regulation A might find the cost-effective method of Internet communications particularly advantageous. But while cruising down the information superhighway, look out for the potholes and cops.


1996 A. Jared Silverman. All rights reserved.

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