Speech by SEC Acting Chairman:
Raising Capital on the Internet
Acting Chairman Laura S. Unger
U.S. Securities & Exchange Commission
At the 2001 Corporate Law Symposium
University of Cincinnati School of Law
March 9, 2001
Thank you. I'm pleased to be able to participate in this year's Corporate Law Symposium, and appreciate having the opportunity to comment on how technology is changing the capital-raising process. My tenure on the Securities and Exchange Commission almost three and a half years has coincided with the Internet's challenge to traditional capital markets and the regulation of the markets. Technology has been one of my primary interests at the Commission.
The financial services industry has been uniquely susceptible to changes in technology due to its inherently intangible nature. Financial services consist mainly of information flow from broker to customer (investment information); customer to broker (placing orders); broker to market center (order entry); market center to clearing broker (order execution) and finally back to the customer (confirmation). As former Commissioner Grundfest has observed, "Financial services transactions lend themselves perfectly to electronic media since they do not involve the movement of physical things to achieve clearance and settlement."
The popularity of the Internet is linked with the explosion of retail online brokerage. The Internet has also affected the capital-raising process in an equally fundamental way. The vast majority of established public companies have taken advantage of three clear benefits of raising capital online: (1) quick, broad dissemination of information, (2) continuous availability of massive amounts of financial and investment information, and (3) reduced costs. I'd like to spend a little time on each of these topics.
Broad and Fast Dissemination of More Information
The Internet provides companies direct access to a huge pool of investors and prospective investors. The Internet enables a company to distribute its offering materials to the broadest possible audience and to solicit interest in its securities without regard to location. This has proved a boon for new businesses without an established investor base as well as for established corporations seeking to leverage their name recognition on a global basis.
Technology has also encouraged issuers to consider and develop new ways to present information to prospective investors. We are starting to see many creative uses of the Internet to tell a company's story. Electronic prospectuses can, and do, include video, sound, graphics and interactivity. Consistent with staff no-action letters on electronic roadshows, some companies provide opportunities for real-time question-and-answer periods with company officials as part of a simultaneous electronic broadcast of a live roadshow.
Lower Cost of Capital
The use of electronic media to disseminate offering materials has some obvious economic advantages. It drastically reduces costs associated with the capital formation process printing and distribution costs as well as advertising and promotion expenses. Electronic offering materials can also be supplemented and updated more efficiently and economically. These savings have significantly reduced the cost of capital, particularly for smaller businesses where such costs take a significant chunk out of the total offering proceeds.
In addition, as I will discuss shortly, new underwriting techniques such as the "dutch auction" offering format provide other advantages such as new efficiencies that may ultimately dramatically lower the cost of capital. These techniques streamline the offering process, reducing underwriting expenses and increasing offering proceeds. In the case of direct public offerings, underwriting expenses are dispensed with entirely.
Capital Raising Online
The advantages of the Internet have not gone unnoticed by the issuer community. Until very recently, the volume of online public offerings has grown consistently. Issuers use the Internet for a host of offering-related functions, ranging from simple promotions involving the dissemination of basic information about an offering to the actual offer and sale of securities. Many public offerings today include an electronic component and most underwriting syndicates include one or more online brokerage firms.
Beyond just extending the reach of the traditional capital raising process, however, technology has created a number of alternate methods for offering securities.
Direct public offerings. In a direct public offering, shares are offered directly to prospective investors online, bypassing the traditional underwriting process. Some smaller businesses that lack either the resources or the stature to attract an underwriter or banks or insurance companies with a built-in investor base that are converting to stock corporations view the direct public offering as an attractive alternative. The first direct public offering via the Internet was conducted five years ago by Spring Street Brewery in 1996, and approximately 200 direct public offerings have taken place since then.
There are some investor protection concerns with direct public offerings, however, that the Commission is monitoring closely. Traditionally, underwriters have acted as a "gatekeeper" to the offering process. They conduct due diligence about the issuer and the offering, participate in preparing the registration statement, make pricing decisions, and provide research and aftermarket support. Without an underwriter to perform this independent gatekeeping function, investors must rely exclusively on the issuer to carry out these responsibilities. Issuers would also retain sole liability for material omissions and misrepresentations.
Online public auctions. One of the common complaints about underwritten offerings is the imprecision of the pricing process. In the latter stages of the recent bull market, it was not uncommon for newly-issued securities to trade well above the offering price in the period immediately after an initial public offering. Of course, this phenomenon largely fueled the intense investor demand for a share even just one of an IPO.
In practical terms, the "pop" in price that was realized in the secondary market translated into lost dollars for the company raising capital. To address this situation, some brokerage firms have begun using an online "auction" pricing approach. Under the "auction" model, prospective investors submit bids for the amount they are willing to pay for the securities being offered. After the bidding, the offering price is set at the highest price at which the entire offering can be sold, with all investors paying the same price. In theory, by more accurately gauging market demand, the auction process should result in the maximum amount of offering proceeds for the company, while ensuring a more equitable distribution of IPO shares.
So far, electronic auctions have proved most successful for follow-on or shelf offerings, although underwriters have started using online auctions for IPOs. At the end of January, Peet's Coffee & Tea went public using a dutch auction pricing system. The offering was priced at $8.00 per share, but in the days following the offering, the stock price more than doubled, belying the notion that an auction ensures that the issuing company raises the maximum amount of money that the market will bear but perhaps proving that secondary market trading in IPOs is still vigorous.
Regulatory Issues in Online Capital-Raising
Creative use of the Internet for capital-raising will continue to develop, but issuers will not be able to take full advantage of the enormous capability of the Internet to disseminate information about both public and private offerings until the Commission revisits some of the current legal and regulatory restrictions on issuer communications during the capital raising process. Many of these issues are rooted in a regulatory system that was designed for a paper world, a system that often appears at odds with the very benefits that flow from technology broader and faster dissemination, more information and reduced cost.
The Commission's 2000 release on the use of electronic media ("2000 Release") made some incremental progress towards recognizing the impact of the Internet on public and private offerings. Most commenters expressed frustration that the release did not go far enough in reconciling the requirements of the Securities Act of 1933 ("Securities Act") with electronic realities. To accommodate the reality of the Internet, commenters suggested major changes to the conceptual framework governing the offering process.
They called for deregulating oral and written communications in the pre-effective period. In particular, they called for eliminating the distinction between oral and written communications to permit both a broader range of routine e-mail communications with investors about offerings and wider access to electronic roadshows. For private on-line offerings, commenters called for eliminating the prohibition against "general solicitation or general advertising" so long as sales are made only to sophisticated or accredited investors.
Let me explain what this means. When a company is contemplating a securities offering, the securities laws severely restrict that company's communications with the public. The purpose of these restrictions is to ensure that the prospectus is the primary vehicle for communicating information about the offering and to prevent other communications from being used to "condition the market" for the offering. As a result, "gun jumping" concerns influence virtually every communication with the public in the weeks and months preceding a registered offering. Companies are counseled to "scrub" their websites regularly so that postings on their sites are not interpreted as "conditioning the market."
But are these restrictions necessary for every company in today's markets? Take any Fortune 500 company. Most likely, numerous analysts follow this company, it has a fairly sophisticated Internet web site and releases information about its activities constantly. Current technology reports all of this information to the market almost instantaneously. Placing restrictions on this company when it is planning to raise capital through a securities offering may not make a lot of sense. Any communications by the company are unlikely to have a significant impact on conditioning the market or stimulating interest in the proposed offering.
Moreover, given the difficulty of predicting, in hindsight, whether a statement is going to be considered an impermissible "offer" of securities, many companies severely limit communications when contemplating an offering. This poses significant problems when the company has a web site, as most companies do, but it's an even bigger problem when the company's web site is an integral part of its business.
To take advantage of the ease of communicating via the Internet, some commenters have suggested that the Commission permit a broader range of written communications during the pre-effective period. One possibility is to expand Rule 134 under the Securities Act to include factual, non-sales information such as term sheets, comparable market prices for similar securities, road show calendars, and dealer commentary regarding timing and book-building.
For a company using electronic communications media, the quiet period between filing and effectiveness presents a dilemma. During that period, a company can only use written or broadcast offering materials included in the prospectus, while oral communications are generally permitted.
Electronic communications do not always fit neatly into one category or the other, however. Is an "e-mail" message a "written" or an "oral" communication? While often thought of as a substitute for telephonic communications, e-mail messages are fixed in graphic form, can be retained and often are much more detailed than oral conversations. Because of concerns that these communications can easily influence prospective investors, the Commission staff has been reluctant to characterize these communications as other than written communications.
Another regulatory challenge involving the traditional securities offering is the management "roadshow." Previously, roadshows consisted of a live presentation by the executive officers of the issuing company to broker-dealers, investment advisers and institutional investors. Many public companies have begun broadcasting their road shows on the Internet to this same audience. Benefits of electronic roadshows include lowering the cost of promoting an offering, while reaching a wider audience, reducing wear-and-tear on company executives and providing a consistent message to prospective investors.
But is a roadshow a written or an oral communication? The answer to this question is significant since it influences the form and content of what can be discussed in the presentation. In a traditional road show, company executives made an oral presentation and any written or graphic materials used during the presentation were collected before participants left the room. With an electronic "road show," the appropriate protocols are not so clearcut.
And who can access an electronic roadshow? The staff has permitted traditional roadshow invitees such as broker-dealers, investment advisers and institutional investors to view electronic roadshows, as well as high net worth individuals and certain sophisticated investors. But why shouldn't all retail investors have an opportunity to view electronic roadshows? Audience sophistication is irrelevant in the case of a public offering, as long as a prospectus is furnished to attendees. Staff no-action letters on electronic roadshows make clear the Commission's concern about issuers' developing one version for market professionals with earnings projections and other financial information and a "dumbed-down" version for retail investors.
To finish up on roadshows, commenters have also noted that current no-action letters require electronic roadshows to be live or recorded transmissions of roadshows that are or actually were presented live. Commenters said that electronic roadshows should also be available in an "Internet-only" form.
In the case of online "auctions," some broker-dealers conduct the auction on the Internet and permit prospective investors to view the auction "live" as it progresses. Since the price is not determined until the end of the auction, there has been some concern that viewing the auction as it takes place might mean that the auction screens are offers to sell the securities that would trigger prospectus rules. To resolve this concern, broker-dealers have made the auction accessible only via a hyperlink from within the offering prospectus, and they also file copies of the auction screens as part of the prospectus.
Clearly, it is not good policy to hinder electronic communications when allowing them would benefit to issuers and investors. Our Division of Corporation Finance is in the process of drafting a rule proposal that I hope will permit more and better communication during the initial stages of the capital raising process.
Online Private Offerings
To this point, I have focused primarily on registered offerings, but technology has also made the Internet an effective medium for raising capital privately. One of the concerns expressed by commenters on the 2000 Release with respect to online private offerings relates to the prohibition against general solicitation. The prohibition was originally intended to ensure that access to private offerings was limited to sophisticated or accredited investors who do not need the protections of the federal securities laws. The Commission has indicated that, under certain circumstances, websites affiliated with registered broker-dealers may be used to raise capital privately as long as prospective investors are screened before they are allowed to view the offering materials.
The popularity of the Internet as a means of connecting investors with issuers has put squarely on the Commission's plate the question of how to regulate "offers" of securities in both public and private offerings in the Internet age. Does it make sense to regulate communications during the pre-effective period? Who should be able to access electronic roadshows and should they be open to all investors? Perhaps now is the time to consider regulating offers at the point of sale.
I intend to work to facilitate further advances in the use of electronic media for capital raising. Issuers and investors should have the benefit of the best that these developments have to offer.