Speech by SEC Commissioner:
Raising Capital in Bits and Bytes
Laura S. Unger
Commissioner, U.S. Securities & Exchange Commission
At the Ninth Annual New England Securities Law Conference
June 11, 1999
Today, I want to talk about one of my favorite topics -- how technology is exerting its influence on the securities markets.
Before I begin, I must give the standard SEC disclaimer that the remarks I'm about to give are mine and mine alone, and do not necessarily reflect the views of the Commission, its staff, or the other Commissioners.
Two recent announcements amply illustrate the depth of change that the securities industry has undergone in the past five years. We are now seeing the convergence of full service and discount firms -- the two ends of the financial services spectrum -- due to the rise of online trading.
A major offline firm, after much debate, announced that it would let investors start trading online in a few months. A major online firm that began its life by offering no frills execution services announced an agreement to buy an insured online bank in order to give customers a full range of financial options. . . . It's heartening to see that it isn't only banks that are buying securities firms but that occasionally, a broker buys a bank.
There can be no question that the Internet is bringing changes to the process of buying and selling securities in this country. Today, about 16 percent of equity trades occur online. So far, however, if you think of secondary trading as being at the epicenter of an earthquake, primary offerings are only beginning to feel its tremors.
It was only 1996 when Spring Street Brewing first decided to bypass a broker in offering its shares online directly to investors. Spring Street did not raise very much -- about $1.6 million. What it did not capture in capital, however, it captured in imagination. After the offering, its founder decided to create an Internet broker to act as an e-manager with the goal of bringing IPOs to online retail investors on a first-come first-serve basis.
At least one California broker has taken a page out of Spring Street's book and created an online listing service that attempts to match startups with wealthy sophisticated investors who invest alongside venture capitalists and institutions. Prospective companies are required to pass an interview process with the broker and pay a listing fee in order to list in the "heaven" area of the website. They can also pitch their ideas before prospective investors at a monthly "showcase" event. Even the Small Business Administration has created a site for small issuers seeking these types of investors, aptly named ACE-Net, or the Angel Capital Electronic Network.
Another investment banking firm on the West Coast recently decided to attempt a rewrite of the "rules" for underwriting securities by offering IPOs through a Dutch auction process that allocates shares to the highest bidder.
The theory of this system is to price IPOs more closely to the real value of the security -- an interesting idea when you consider the runups in prices of most Internet IPOs. Last January, IPO prices rose nearly 250 percent on the first day of trading. They have since come down to more "modest" runups of 75 percent in May. This system was also supposed to make IPOs more accessible to retail investors, albeit retail investors who bid the highest.
Still, the Internet has not yet democraticized investor participation in offerings. The total share allotment in the first quarter of this year to online brokers who sell IPOs to retail investors was just two percent on average. According to one source, the final number allotted to e-brokers may have actually been even lower because lead underwriters tend to keep most of the allocation for themselves.
The number of e-mails saying "sold out," and e-mails to our complaint center, suggest to me that lack of access to IPOs in general is a pervasive source of frustration for your average investor. If the IPO frenzy continues, perhaps the Dutch auction concept will get more IPO shares in the hands of retail investors.
Another source of frustration for an increasing number of investors is their lack of access to analyst calls. An Internet industry magazine recently noted that a remarkable amount of information is still only available to institutions. As an example, analysts and fund managers can quickly connect to top executives, including many CEOs. Companies discuss earnings or make major announcements during conference calls which tend to be closed to all but a select group. According to this article, it is not unusual for an analyst listening to a call on one line to be directing trades on another line before the information is made public.
In the age of the Internet, technology can actually cure this problem by widely disseminating information at the same time to all interested investors, and at a reasonable cost.
For example, a couple of technology companies have announced that they would carry conference calls live and offer investors the ability to send questions via e-mail during the call. Another company has set itself up as the "TV Guide" of conference calls so that investors can easily find out about them.
Even the regulators have gotten into the act. Nasdaq launched a pilot program in December to encourage the 100 largest issuers to broadcast their conference calls over the Internet. Some of the largest issuers, such as Intel, Cisco, and Amazon.com, are broadcasting their calls. These are very positive developments. I hope that all issuers follow this lead and open up their calls to interested investors.
Speaking of hidden information, I want to talk briefly about one of the Commission's most paper and time intensive rulemaking proposals -- the proposals to modernize the Securities Act of 1933. For those of you who do not have time to read the 500-plus page proposals, a plain English 25-page summary is now on the SEC website. The proposed revisions to the '33 Act would, among other things:
- lift the current restrictions on communications around the time of an offering for large companies and any companies selling to sophisticated investors;
- allow all companies to use sales material other than the prospectus; and
- require companies and their underwriters to deliver prospectus information to investors before they make their investment decisions.
As the Commission noted in the proposing release, however, the rulemaking leaves a number of policy questions with technological implications yet to be resolved. In addition to what will be resolved later in the '33 Act proposals, the staff of the Division of Corporation Finance is working hard at examining some of the more pressing technology-related questions involving offerings and should have something to present to the Commission later in the year. I'll just touch on a couple of these tough issues for now plus a couple of other issues that we will likely not address in rule proposals.
First, the '33 Act proposals would open up communications during the traditional waiting period around the time of an offering. Allowing the use of "free writing" would allow companies to use the Internet to broadcast their roadshows both to retail and institutional investors, to hold chat room discussions about their offerings, and to use e-mail to answer investors' questions.
Written information would have to be filed with the Commission and free writing would be subject to Section 12(a)(2) liability. Section 12(a)(2) of the '33 Act allows purchasers to recover against the sellers for false or misleading statements or omissions unless the sellers can show, after exercising reasonable care, that they could not have known of the false or misleading statements or omissions. Underwriters are most often subject to Section 12(a)(2) liability.
But what exactly is a "writing" in cyberspace? This question does not lend itself to an easy resolution. The breadth of the Commission's definition of a "writing" will dictate what types of future communications will have to be filed with the Commission in connection with the offering. As a result, characterizing different types of technology, whether CD ROM, Internet chat rooms, Internet telephony, or streaming audio and video, as "writings" could lead to different treatment.
Today, in theory at least, the Commission's definition of "writing" capture all electronic communications. In practice, however, we have not objected to issuers and underwriters playing roadshows over the Internet to a limited audience -- typically composed of institutional investors. While we do not necessarily agree
with this analysis, the securities industry has argued that online roadshows made available to a limited audience are not "written" although they are electronic communications.
Since electronic roadshows in fact allow more investors access to useful information, the staff has not objected when the roadshow still reaches a limited number of investors in a limited way.
Other federal regulators also are struggling to categorize electronically transmitted information. For example, the Federal Trade Commission requires that certain communications be in writing. To clarify what is a "writing" in the electronic medium, the FTC proposed last year to include electronic material that could be preserved in a tangible form and read.
The Federal Reserve Board, in a rule regarding Electronic Funds Transfers, defined the term "electronic communications" more broadly to include visual text that could be displayed on a computer screen. Required "written" information would have to be in a format that could be preserved, that is, printed or downloaded by the consumer. As you can see by these examples, the common thread is the ability to preserve information.
A second major unresolved issue involves hyperlinks. Many issuers want to post hyperlinks to other sites such as analysts' research reports and earnings projections. The ability to hyperlink makes using the web a seamless experience.
Right now, hyperlinking to online sales literature and research reports "entangles" the issuer with that information so that it is presumed that the issuer is providing that information directly to investors from a liability standpoint. Incorporating any hyperlinked information into the registration statement would create potential Section 11 liability for issuers for any materially false or misleading statements or omissions contained within or linked to their websites.
To take an offline analogy, the hyperlinked information is in the same "envelope" as the issuer's information. It is easy to figure out where documents are used together offline because they are contained in a single three-dimensional envelope. But where does the envelope end if issuers hyperlink to third parties who in turn hyperlink to other parties? I guess you could call this "the law of unintended consequences meets the envelope theory."
Regulators have dealt with the issue of hyperlinks in the broker-dealer context because many online firms have hyperlinks to third party research services. In a 1997 letter to the ICI, the NASD opined that a broker is not responsible for the content of the material posted on an independent third party's website to which it has established a hyperlink, and is not subject to NASD filing requirements if two general conditions are met. First, the link must be ongoing. This means that the link:
- is continuously available to investors;
- contains information that cannot be altered by the broker; and
- is accessible to investors, which may include favorable or unfavorable information, even if it is updated or changed by a third party.
Second, the third party must be independent from the broker and its affiliates.
We will have to deal with this issue in the offering context.
An issue that we will have to confront eventually is how the Internet will change issuers' roles in providing the required disclosures to investors. For instance, should the burden of prospectus delivery fall on the issuers delivering the prospectus or on investors accessing it on the issuers' websites?
In shorthand, it's the debate about "access" versus "delivery." Although it makes sense for the future, I think that switch in responsibilities, if it ever comes, is still too early for several reasons.
First, we cannot presume that everyone has access to the Internet. A recent study published by Professors Donna Hoffman and Tom Novak of Vanderbilt University concluded that most web users are under the age of 46. This means that a significant portion of our population remains largely unplugged. According to Forrester Research, only seven percent of households with brokerage accounts are investing online. It is possible that a much higher percentage would be willing to receive required disclosures online, but these statistics tell me that it is still too early for access instead of delivery.
Second, add the burden of shifting the cost of printing long documents to investors and we have an issue that is not quite ready for prime time but coming soon to a regulator near you. If we do move to shifting from a system of delivery to a system of access, the quid pro quo should be that the entire prospectus would be a shorter, plain English and more user-friendly document so that investors could read parts of interest directly on the screen.
Saving the most difficult question for last, the Commission needs to address the issue of sales of securities in the international context. In March 1999, the Commission issued its second exemption ever from exchange registration, which happened to also be its first exemption to a foreign exchange. In granting a limited volume exemption to a U.K. exchange, Tradepoint, the Commission permitted U.S. institutional investors to trade securities that are solely listed on the London Stock Exchange without going through an intermediary.
However, we granted the exemption because Tradepoint is an exchange that only does a limited volume of transactions. If Tradepoint's worldwide average daily trading volume exceeded ten percent of the volume of the London Stock Exchange, the Commission would reevaluate Tradepointís exemption from exchange registration. The Commission specifically noted in granting the exemption that we are still assessing the impact of U.S. investors trading unregistered foreign securities and the long-term regulatory approach that we should take.
Recent trends that give U.S. investors greater and more instantaneous access to foreign securities markets creates tension between the competing goals of letting U.S. investors trade securities more efficiently and requiring issuers whose securities trade in the United States to make full and fair disclosure. As most of you know, the key to opening up foreign markets to U.S. investors is reaching agreement with our foreign counterparts on the accounting standards that should apply.
The Commission and foreign securities regulators, through the International Organization of Securities Commissions, are seeking resolution to this issue by working with the International Accounting Standards Committee to develop a core set of accounting standards that could be used in cross-border offerings and listings. Our current rules allow foreign filers to use international accounting standards, provided they reconcile their financials to U.S. GAAP.
In December 1998, the IASC approved the last major project in its core standards. Earlier this year, IOSCO and the SEC began their assessment of the substantially completed core standards. If after its assessment, IOSCO endorses the IASC's core standards for use in cross-border offers and listings, the Commission would likely consider to amend its current filing requirements to reduce or remove the current requirement to reconcile financial statements to U.S. GAAP.
As part of the Commission's assessment of the core standards, the Commission staff is currently working on a concept release to seek input from the investing public regarding some of the key issues that have been raised relating to international accounting standards.
As a footnote to the nonfinancial but still international front, the SEC proposed this spring to update the disclosure requirements that foreign issuers have to follow to access the U.S. markets. The proposal is based on the international disclosure standards adopted by IOSCO in 1998. The proposal would replace the international disclosure standards found in our basic disclosure document for foreign issuers, Form 20-F. The adoption of these standards by the SEC will help make the disclosure document a "passport" to global capital markets by reducing the barriers to cross-border offerings and listings.