volume 1 number 2 JUly 1999

RAISING CAPITAL ON THE INTERNET THE SEC ADJUSTS TO INTERNET PUBLIC OFFERINGS AND VIRTUAL SECURITIES MARKETS

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On October 6, 1995, the SEC issued an interpretive release providing guidance on the use of electronic media, including the Internet, for the delivery of information to investors. Within months, Spring Street Brewing Co., using a financing vehicle known as a "direct public offering" or "DPO," became the first company to offer its securities directly to the public via the Internet. Without the assistance of an underwriter, this “paperless” DPO reportedly raised $1.6 million from 3,500 individual online investors. Since then, the Internet has radically transformed the way in which brokers-dealers, investment bankers and companies have conducted their capital-raising activities. The speed with which this transformation has taken place has been almost numbing. The first online broker opened for business in 1995 – the same year as Spring Street’s DPO. Today there are an estimated five million online brokerage accounts, and DPOs using the Internet, while not yet commonplace, have become a viable alternative for smaller companies that previously looked only to traditional financing vehicles. The SEC has responded to these changes with significant regulatory initiatives. However, given the rapid pace of change it should come as no surprise that the SEC is still feeling its way. The federal securities laws were first enacted over six decades ago. Much of the technology that forms the basis of the online securities industry was developed within the last five years. As SEC Commissioner Laura S. Unger recently noted, no one is quite sure how “SEC.gov” can best regulate “Securities.com.“ This issue of Stroock Capital Markets looks at some of the SEC’s recent initiatives, and some of the issues that remain to be addressed. It reviews developments relating to the electronic delivery of information generally, and the

advent of Internet public offerings in particular. It looks at issues relating to Internet road shows. If nothing else, this issue of Stroock Capital Markets should make one thing clear: no one should assume that because capital-raising activity takes place on the Internet, it is exempt from regulation. On the contrary, the SEC’s jurisdiction extends into cyberspace, and some state regulators have also staked out claims. And just as technological innovation will continue to create new opportunities in the securities industry, so too will that innovation require changes to the securities laws. Through it all, an understanding of the evolving regulatory framework is indispensable. ▼

SEC Reshaping Old Regulations to Fit New Technologies

Direct Public Offerings on the Internet: A Primer for Small Business Microbrewery Taps Potential of Internet DPOs; Investment Banking Goes Online The do-it-yourself online DPO by Spring Street Brewery generated considerable media attention. The public’s fascination with all things Internet was just hitting its stride, and here was hard evidence of the convergence of Wall Street and the multimedia superhighway. To cash hungry start-ups, Internet DPOs promised easier access to seed capital – a cost-effective alternative to angel capital, bank loans and venture capitalists. For web-savvy individual investors, they offered the opportunity to get in on the ground floor – to buy shares in IPOs at the initial offering price. Investment professionals and securities regulators cast a watchful eye, waiting to see what came next. They didn’t have to wait long. Now that the potential of the Internet for

offering securities to individual investors had been demonstrated, the logical next step was an Internet-based investment bank. That came in July 1996 with the formation of Wit Capital Corp., billed as the first investment bank and brokerage firm doing business exclusively on the Internet. To some, Internet DPOs and Internet underwriting promised a future with enormous cost savings for issuers and investors. Among other savings, issuers would no longer have to foot the bill for printing and mailing paper prospectuses. Since Internet underwriters could deal directly with individual investors, brokerage commissions could be eliminated or substantially reduced. Though that future has yet to be fully realized, Internet DPOs and online investment banking have experienced considerable growth during the past two years. Wit Capital Corp. participated in its first public offering in 1997, acting as “e-manager” (the term coined to describe the co-manager in charge of online distribution of shares in a public offering), in the IPO of Radcom Ltd., a developer and manufacturer of testing and analysis equipment for data communications networks. Today, a company considering a DPO, and investors looking to get in on the ground floor of IPO’s, can choose from a dizzying array of web-based underwriters, broker-dealers and websites “hosting” information about online IPOs and DPOs, including Direct IPO, Direct Stock Market, dpoCentral, E Investment Bank, E*Offering, IPO.com, IPODesktop and Open.IPO, to name only a few.

Internet DPOs While the appeal of a DPO – cutting out the middleman, going straight to the public – is undeniable, DPOs aren’t right for every company. The following is a brief look at how DPOs work, and some of the advantages and disadvantages of DPOs for small businesses. 1. Advantages of an Internet DPO. Internet DPOs have definite advantages for some companies – particularly small businesses looking for alternatives to more traditional financing vehicles. Among these advantages are: • Ability to reach potential investors worldwide. In an Internet DPO, the issuer and the underwriter (if one is involved) can target as broad or as narrow an audience of potential investors as they choose to reach (subject, of course, to applicable regulatory restrictions). Many DPOs have been marketed to selected groups of potential investors who have some affinity for the issuer or its products. In the eyes of some companies, this results in more supportive shareholders. For many DPO issuers, an added benefit is that they can reach a large number of potential investors without the costs and subsequent reporting requirements of a registered offering. Of course, the reverse of this coin is that investors are deprived of some of the disclosure protection afforded by registered offerings.

• Faster and cheaper dissemination of offering materials. Though there can be technical problems in posting materials on the Internet, as a general matter, distribution of offering materials via the Internet is faster and less expensive than printing those same materials and distributing them via the mail. • Elimination or reduction of underwriting fees and commissions. It is more feasible for most small companies to conduct a DPO on the Internet without using an underwriter than it would be for those same companies to effect a paper-based self-underwritten offering. Even if an underwriter is involved in a DPO, the underwriting fees and commissions may be less than in a traditional offering. 2. Disadvantages of a DPO. • In self-underwritten DPOs, due diligence will be conducted only by professionals retained by the company. To many potential investors, this is problematic. • There is often a lack of liquidity because of the lack of market makers and research coverage, and, since the offerings are generally small, a commensurately small “float.” • Even when an underwriter is involved, DPOs have sometimes been viewed as the option of last resort for companies that are not “good enough” to obtain more traditional forms of financing. 3. Regulatory Considerations for Internet DPOs. • Unless the offering is limited to persons who consent to electronic receipt of the offering materials, paperbased delivery must still be available. • Even where all investors have consented to electronic delivery of the offering materials, consent can still be revoked if notice of revocation is given a reasonable period of time prior to the electronic delivery. • If an investor doesn’t provide an e-mail address at which to be notified of the availability of offering materials, the investor will likely have to receive paper-based notification by mail. • Other than in Regulation A offerings, preliminary solicitations of interest are still prohibited and considered “gun-jumping.” This could be the result where, for example, a company posts certain types of promotional material on its website shortly before filing a registration statement. Conversely, material posted on a company's website shortly after it has filed a registration statement may be deemed to be an illegal prospectus. -2-

4. Online Underwriters and Other Firms Assisting With DPOs. As noted above, there is a large group of online investment banks, broker-dealers and other firms that assist companies with Internet DPOs. OpenIPO, for example, employs what it refers to as a “modified Dutch auction” process to price its offerings and allocate shares to investors. Potential investors (all of whom must have a brokerage account with a brokerdealer that is a member of the “OpenIPO Network”), submit private bids listing the number of shares they want to buy, and the price they are willing to pay. When the bidding period closes, the winning bids are selected from the list of bidders, starting with the highest bidder and going down the list until all of the offered shares have been sold. All of the shares are sold at the bid price of the lowest bidder whose bid is accepted. E*Offering sells shares only to investors that have accounts with E*Trade. It reportedly plans to concentrate on equity offerings in the $25 million to $50 million range, and intends to distribute up to 50% of every IPO or secondary offering it manages to E*Trade customers. Another firm, IPODesktop (the online service of Friedman, Billings, Ramsey Group, Inc. (“FBR”), a New York Stock Exchange listed full-service investment banking and asset management firm) limits sales to “qualifying” individual customers. FBR has indicated that it will make up to 20% of the shares it receives in an offering available to IPODesktop customers. Other firms, such as dpoCentral and IPO.com, are “listing services” that “host” information about companies seeking investors, and make that information available to "qualified" individual investors interested in investing in online IPOs and DPOs. Some of these firms also provide, or make referrals to firms that provide, Blue Sky, business consulting and other services companies involved in a DPO may require. 5. How Internet DPOs Have Fared. Recently, shares of Salon.com, an online magazine, were offered through OpenIPO. The shares were priced at $10.50 a share, compared with a hoped-for $13.50 a share. However, the Salon.com sale was unique in that it involved the “modified Dutch auction” system described above, so it is difficult to draw any firm conclusions as to why the offering didn’t receive a more enthusiastic reception. In fact, DPO’s have achieved mixed results – some trading below their initial offering price, and others attracting more investor interest, with

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• Foreign jurisdictions have not provided much guidance to date regarding procedures to be followed by United States issuers in Internet DPOs.

corresponding gains in their share price. What can be said is that although DPOs offer advantages, they will not transform an unattractive company into an attractive one. ▼

• Compliance with "Blue Sky" laws is still necessary. The position of many states regarding Internet offerings remains unclear.

The SEC’s Developing Roadmap for Cyberspace Electronic Delivery of Information: From E-Mail to the Internet Before 1995, it was unclear what procedures issuers and underwriters needed to follow, and what requirements they needed to meet, in order to take advantage of emerging technologies like the Internet to deliver offering materials and other information to investors. That changed as the result of the SEC’s October 6, 1995 interpretive release and a series of no-action letters and interpretive releases that followed. In these no-action letters and releases, the SEC staff established the basic ground rules for electronic delivery of information, including prospectuses, to investors. The SEC staff stated that electronic delivery of information is equivalent to “paper-based” delivery if four basic requirements are met: 1. Content and Format. Information delivered in electronic form must be substantially equivalent to information the recipients would receive if the information were delivered to them in paper form. For example, paper-based delivery affords recipients the opportunity to retain a permanent record of the information received. Electronic delivery must afford recipients the same opportunity. Formatting requirements relating to the physical attributes of documents, such as choice of font and type size, may be modified as appropriate for documents delivered in electronic form, provided the information in the electronic version is presented in a format that is “readily communicated” to recipients. 2. Delivery. The sender must reasonably believe the intended recipient will actually receive the information being delivered in electronic form. The SEC staff has noted that delivery of information through postal mail provides the sender with reasonable assurance the intended recipient will actually receive the information, and any method of electronic delivery that provides assurance comparable to paper delivery will satisfy the delivery requirements of the Securities Act. It provided a non-exhaustive list of methods meeting this standard, including the following: • obtaining express consent from an investor to deliver information via electronic mail and then sending the information to the e-mail address provided by the investor; -3-

• obtaining express consent from an investor to deliver information via a website, providing appropriate notice to the investor (via electronic or paper means) that the information has been posted on the website and ensuring the website is reasonably accessible; and • obtaining evidence that an investor actually received the information – for example, by electronic confirmation that e-mail has been received or information has been downloaded or accessed via the Internet or other electronic means. 3. Notice. The sender must have a reasonable basis for believing the intended recipient of information delivered in electronic form will receive timely and adequate notice the information has been sent. The SEC staff noted that when an electronic document itself is provided – for example, on computer disk, CD-ROM, audiotape or videotape, or via e-mail – delivery of the document is generally sufficient notice. However, if information is posted on a website, separate notice would be necessary, unless the sender can otherwise verify receipt by the intended recipient of the information. 4. Access. Recipients of information in electronic form must have access to the information comparable to the access they would have had to a paper document. The SEC staff emphasized that use of a particular electronic medium should not be so burdensome that recipients will be unable to access the information. If information is provided on a website, through an online service or by other similar means, the information should be accessible for as long as the delivery requirement applies. In addition, the recipient should have the ability either to retain the information or have ongoing access equivalent to retaining a personal copy.

Internet Offerings Under Section 4(2) of the Securities Act of 1933 and Rules 505 and 506 Thereunder Under Rules 505 and 506 and Section 4(2) of the Securities Act, a securities offering may be exempt from registration if it is conducted without any general solicitation or general advertising. The SEC staff has taken the position that posting offering materials on a website accessible to the general public constitutes general solicitation and advertising unless special procedures are adopted. These procedures are as follows: 1. Pre-Qualification of Potential Accredited or Sophisticated Investors. Making a purchaser questionnaire available on a website to qualify or pre-qualify accredited or sophistic-

ated investors does not constitute general solicitation or general advertising if neither the invitation to complete the questionnaire, nor the questionnaire itself, refer to any specific securities transaction. 2. Offering Materials on Password Protected Website. An investor is provided access to offering information on a password-protected website only after the investor pre-qualifies as an accredited or sophisticated investor. 3. Purchase Limited to Pre-Qualified Accredited or Sophisticated Investors. An investor cannot purchase securities offered on the password-protected website until after pre-qualification as an accredited or sophisticated investor.

Internet Offerings Under Section 3(a)(11) and Rule 147 of the Securities Act Issuers and broker-dealers that post on the Internet any information about securities offered pursuant to Section 3(a)(11) and Rule 147 of the Securities Act, must clearly indicate that offers and sales of such securities are limited to residents of the particular offering jurisdiction.

Internet Offerings Under the “Test-the-Waters” Exemption of Regulation A An offering circular permitted under Rule 254 of the Securities Act can be posted on the Internet or distributed to potential investors by e-mail. The electronic offering circular can include a detachable coupon returnable by e-mail, on which the potential investor can include its name, address, telephone number and indication of interest. This can prove to be very cost-effective, since if there are sufficient preliminary indications of interest, it is possible the offering can be expanded. Because sales under Regulation A are prohibited until the expiration of a 20 calendar-day waiting period from the last publication or delivery of a test-the-waters offering circular, the offering circular should be removed from the Internet at least 20 calendar days before the sale of the offered security.

Electronic Road Shows in Registered Offerings In most public offerings, the managing underwriter organizes “road show” meetings designed to generate interest in the offering. These meetings provide an opportunity to introduce management to potential investors and investment professionals who are invited to attend. These typically include portfolio managers, investment advisors, broker-dealers, industry analysts and institutional investors. Sometimes individual investors also are invited. Once securities offerings went online, it was only a matter of time before road shows hit the Internet, too. The underlying rationale is the same for both: cost savings and faster dissemination of information about the offering to a -4-

broader audience of potential investors. Without question, using the Internet to transmit a road show meeting to a number of sites (either simultaneously or on a delayed basis) is less expensive than repeating the road show "live" at each site during a separate meeting. And an Internet road show has the potential to reach a broad audience of qualified investors. One question facing the SEC in connection with registered public offerings was whether electronic road show transmissions (whether on the Internet or some other form of electronic transmission) were "prospectuses" for purposes of Section 2(a)(10) of the Securities Act of 1933. To date the SEC staff has addressed this issue in three no-action letters (Private Financial Network ("PFN"), Net Roadshow I and Bloomberg, L.P.), in which service providers were permitted to transmit road shows electronically to multiple sites. Though the facts were different for each, the no-action letters provide some general guidance to issuers and underwriters about structuring an electronic road show for a registered offering: 1. Limit the Audience. The audience for the electronically transmitted road shows should be limited to the same type of investment professionals and qualified investors that would have been invited to the "live" road show. 2. Limit the Number of Times, or the Time Period, a Transmission Can be Viewed. In PFN, each viewer was to be limited to two transmissions of the electronic road show. Bloomberg and Net Roadshow I proposed that viewers could access the electronic road show as many times as they wanted, but only during a single 24-hour period. 3. Prohibit Copying, Downloading, Printing or Distribution of Road Show Materials. Either: • Require each person who is to be given access to the electronic transmission of the road show to agree, prior to access actually being granted, that he or she will not copy, download, print or distribute all or any part of the transmitted material; or

• Ensure that the method of transmission will prevent copying, downloading or printing all or any part of the transmitted material, and include a message in the transmission warning viewers that copying, downloading and printing is prohibited. Bloomberg proposed that such a message would appear at the beginning and end of each transmission. 4. Importance of Preliminary Prospectus. No electronic transmissions of the road show should occur until a registration statement has been filed with the SEC. No viewer should be given access to the electronic transmission until the viewer has received a copy of the preliminary prospectus, or a means for viewing and printing the preliminary prospectus is continuously available to all viewers during the electronic transmission. Net Roadshow I transmissions were to require viewers, prior to being granted access to the road show transmission, to click a button acknowledging that the prospectus was available for viewing through the site. The Net Roadshow I transmissions were also to include a periodic “crawl” or prominent text, emphasizing the importance of viewing the filed prospectus. 5. Content of Electronic Road Shows. Subject to two exceptions, the live road show should be transmitted in its full, unedited form. The two exceptions are that if a road show is electronically transmitted on a delayed basis: • the transmission can be edited to eliminate “dead time”; and • the transmission can include messages to alert viewers to information that has changed since the time the “live” road show took place. Net Roadshow I and Bloomberg transmissions were to include a periodic “crawl” that would provide a synopsis of any changes since the time the electronic road show was recorded. 6. Interactive Road Shows. In the Bloomberg proposal, if the electronic road show was transmitted in “real time,” the sponsoring

STROOCK CAPITAL MARKETS Stroock Capital Markets is a publication of Stroock & Stroock & Lavan LLP. © 1999 Stroock & Stroock & Lavan LLP. All Rights Reserved. Quotation with attribution is permitted. This newsletter offers general information and should not be taken or used as legal advice for specific situations which depend on the evaluation of precise factual circumstances. For further information on the material contained in Stroock Capital Markets or other matters related to Stroock's practice, please contact Richard Fortmann (Editor) in our New York office. -5-

underwriters were to have the ability to authorize viewers to submit questions via Bloomberg’s e-mail system to a Bloomberg representative during the “live” road show. The sponsoring underwriter could answer any such questions it deemed appropriate.

2. Limit the Number of Times, or the Time Period, a Transmission Can be Viewed. In each Net Roadshow II electronic road show, viewers were to receive a confidential password unique to that road show. The password was to expire no later than the date of the related offering.

7. Show Stoppers.

8. Rule 134(b) Legend.

9. Fee Structures. The issuer or underwriters should be charged a set fee that is not related to the size or success of the offering. Bloomberg indicated that it might give access, on a “pay per view” basis, to non-subscribers.

Net Roadshow II permitted each QIB to distribute road show materials to employees or authorized agents of the QIB. 4. Importance of Offering Memorandum. The procedures discussed above regarding receipt of the prospectus and acknowledgment of the importance of the prospectus and its availability for viewing through the site, also apply to the offering memorandum in Net Roadshow II. ▼

If the registration statement has not yet become effective, the electronic road show transmission must include a Rule 134(b) legend stating that the securities cannot be sold, and offers to buy will not be accepted, until the registration statement becomes effective. Net Roadshow I transmissions were to require the viewers, before being granted access to the transmission, to click a button acknowledging the legend.

3. Prohibit Copying, Downloading, Printing or Distribution of Road Show Materials.

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In the Bloomberg proposal, viewers were to have the ability to interrupt their viewing at any time and view less than the entire road show. It was noted that this corresponded to the ability of members of the “live” audience to arrive late, leave the room at any time, and reenter the room after leaving.

In this issue of Stroock Capital Markets we focused on one side of the online securities industry – online underwriting and Internet DPO's. In the next issue, we look at the other – online trading. Though advertising by online brokerdealers has dominated media attention recently, online trading is growing so quickly that significant business developments and important regulatory initiatives are an almost daily occurrence. Our next issue of Stroock Capital Markets examines a few of these to put the trends in perspective.

Electronic Road Shows in Private Offerings A fourth no-action letter, Net Roadshow II, gave permission to a service provider to transmit road shows through its website on behalf of a seller who was selling securities under Rule 144A to “Qualified Institutional Buyers” (“QIBs”). Rule 144A offerings are exempt from the registration provisions of Section 5 of the Securities Act. One condition for the exemption is that there not be any “general solicitation” or “general advertising” in connection with the offering. Therefore, the issue in Net Roadshow II was not whether the electronic road show transmissions were illegal “prospectuses,” but rather whether they would be construed as “general solicitation” or “general advertising.” With the exception of a few variations discussed below, the procedures proposed for Net Roadshow II electronic road show transmissions are substantially the same as the procedures discussed above for registered offerings: 1. Limit the Audience. The audience for the electronically transmitted road shows in Net Roadshow II were to be limited to (i) institutions that the seller had confirmed were QIB’s, and (ii) employees or authorized agents of Net Roadshow or the seller.

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