Speech by SEC Staff:
Views Into the Crystal Ball
Brian J. Lane
Director, Division of Corporation Finance
U.S. Securities & Exchange Commission
To the Committee on Federal Regulation of Securities,
American Bar Association
November 13, 1999
Although it is becoming overplayed to talk about what the next millennium will bring, I think that it would be timely for me, in my last remarks to this august body as Director of the Division of Corporation Finance, to look forward at what the future may hold in store for capital formation.1 While industry attention is focused on market structure issues, we stand at an equally important crossroads for corporate finance. It has been corporate finance and related technological developments that have contributed to the tremendous prosperity in the marketplace. In this vein, I plan to address two topics: (1) broad reform of the regulatory structure for capital formation, and (2) some areas that may be due for change as a result of the Internet. Of course, these views are my own and not necessarily shared by anyone else at the Commission.
I. The Last Few Years
First, let us take stock of how far we have come during the last half of the decade, both economically and regulatorily. Since 1994, U.S. firm commitment corporate securities offerings have grown from less than $700 billion to more than $1.8 trillion in 1998. During the same period debt offerings rose from $621.3 billion to almost $1.7 trillion. Equity offerings grew from $76.9 billion to $152.7 billion. Initial public offering volume has fluctuated greatly during the 1990s, breaking the $50 billion mark in both 1993 and 1996. So far, 1999 looks to be a record year with the Goldman Sachs and United Parcel Service IPOs. While public offerings have almost tripled from 1994 to 1998, so too have private placements. In 1994, $698.2 billion was placed privately compared with over $1.8 trillion in 1998. Thus, the capital markets have been mushrooming in size.
As for the industry, not only has it been affected by growing volume, but also by innovations in technology. In 1995 there were no on-line investment banks, no on-line road shows, and only one known on-line offering Spring Street Brewing Company. Today we have many on-line investment banks, hundreds of on-line road shows, and regular on-line offerings, most of which are initial public offerings.
From a regulatory standpoint, the SEC first addressed electronic delivery in late 1995. In the almost four years that I have been Director, there have been many further staff and Commission interpretive pronouncements with special emphasis on the Internet.
As for broad regulatory reform, there have been three major efforts this decade. First, an advisory committee led by then-Commissioner Steven Wallman endorsed a "company registration" model that was intended to shift the focus away from a transactional registration model. The Advisory Committee's report was issued prior to the SEC gaining broad-based exemptive authority in the fall of 1996. The other two initiatives were released in 1998, the Securities Act Reform release (informally dubbed the "aircraft carrier") and Regulation M-A. The latter was adopted by the Commission last month while the aircraft carrier, as you know, still is pending.
II. Seven Steps to Deliver the Aircraft Carrier
The broader the attempted reform, the more likely that its weight will drag it down. I think Louis Loss confronted this with his ill-fated rewrite of the securities laws in the early 1980s. Nevertheless, changes in technology, the explosive growth of the private markets, outdated regulatory provisions, and the availability of broad regulatory exemptive authority convinced me that a new theoretical model was needed. I envisioned one that was built on the existing system and attempted to re-rationalize the "crazy quilt" of incremental administrative efforts to adapt a system created in the 1930s to a constantly evolving market. My hope was that the general desire for reform and modernization might be the catalyst needed for a new strategic model rather than a continued patchwork approach.
To date we have received 190 letters of comment. The new model is generally supported by investor commenters such as the Council of Institutional Investors, Consumer Federation of America, AARP, AIMR, AFL-CIO, and state securities commissioners. The rest of the comment is mixed with pointed criticisms of several pieces of the proposals. The least happy groups of commenters were the securities industry and corporate lawyers.
Some observers are already writing the obituary for the aircraft carrier, especially with my imminent departure. To do so, I think, would be premature. If broad reform is to move forward, however, the proposals may well have to be re-proposed to address the criticisms. A joint letter signed by many leading voices of the Bar suggests a re-proposal of more limited intentions; one that keeps intact most of the rules governing the offering process and its forms, but opens communications significantly. The goal of this approach appears to me to continue to patch the current system rather than create a new theoretical paradigm. Many ideas proposed in the aircraft carrier would be adopted by this approach. New paradigms, however, necessitate broad revisions that may be viewed as unwieldy by future generations of regulators. It would be far easier to break up the aircraft carrier proposals into three or four pieces. One possible piece to separate would the portion addressing the conversion of private offerings into public offerings and vice versa. These proposals are needed pending a broader solution and they are not subject to the same level of criticism. The same was true of Regulation M-A. Although it was proposed with the aircraft carrier, it was severable. The Commission adopted the proposed rules last month. The communications regime of Regulation M-A, which is similar to the Securities Act reform project, will prove to be a good test of how much flexibility is warranted.
A. Major Issues
Although separate pieces of reform are advancing, I do not think that it is time to abandon broad-based reform. Whether the Commission chooses to proceed with the broad-based approach of the aircraft carrier, or a flotilla of smaller reform projects, I believe that there are seven steps (or compromises) that could achieve possible consensus. Let me address each.
1. Board Certification
The primary complaint about the proposals from public companies was the director certification provision. A majority of directors would have to certify in the Forms 10-K and 10-Q that they had read the disclosure documents and that they were not aware of any material misstatements or omissions that would render the document misleading. This proposal originated from the Report of the Advisory Committee on Capital Formation. The Committee hoped that such a certification would cause directors to review a document more seriously and therefore cause them to be more effective gatekeepers. While directors who sign the Form 10-K today face potential liability for a material misstatement or omission, even without such a certification, there is worry from public companies that this liability should not be expanded to the quarterly reports because there is typically not enough time for the directors to review drafts before the documents must be filed. In addition, there is concern that a statement that a document was read adds little investor protection but gives evidentiary advantages to plaintiffs' attorneys.
To address the criticism in the context of the aircraft carrier, I believe that the costs may not justify the benefits. This is especially true in that the Commission has taken other steps to increase board of director accountability. In fact, the recent proposals related to the recommendations of the Blue Ribbon Committee would require a report from the audit committee, containing a negative assurance. I would opt to address these issues outside of the "aircraft carrier" context.
2. Pre-Sale Delivery of Prospectus
The securities industry expressed perhaps their greatest dismay at the proposal's premise of mandated prospectus delivery prior to an investment decision. The statute does not require that an investor receive a final prospectus until sale. For over 60 years, as a general matter, the sale has been deemed to take place when the trade confirmation is received. Unfortunately for investors, the confirmation is not received until after the investment decision has been made, a little late for effective disclosure. Rule 15c2-8 requires that a draft (or "red herring") prospectus be delivered to investors in IPOs at least 48 hours in advance, but this is still one day after the transaction is agreed upon under today's three business day settlement cycle. The question is how to ensure that information gets into the hands of investors prior to the investment decision without slowing down the pace of today's rapid capital formation process. The proposals mandated pre-delivery of preliminary disclosure at least seven days in advance for IPOs, three days in advance for repeat offerings to less sophisticated investors by smaller issuers, and anytime in advance for repeat offerings to more sophisticated investors or repeat offerings by larger issuers. For that last group of offerings, with modern technology, we had hoped that sellers could electronically deliver the necessary "term sheet" summaries to investors within minutes of calling them. The industry criticized the proposals claiming that investors did not need this information; even minutes of delay would increase risk and cost; the pre-delivery requirement would preclude adding last minute investors; and the ramifications of a mistake would be too severe.
To address these concerns, I believe several changes are appropriate. First, a pre-delivery requirement should be maintained because it is important to investors, but we should focus on where it is most needed. Clearly it is needed in the IPO context and some secondary offerings by unseasoned companies, but it is less clear where it is needed for large issuers that use the shelf registration system. A term sheet for the common stock of General Motors, for example, is not likely to have any meaningful information. Market price disclosure, which is readily available, is what matters there. The same appears true for investment grade debt that can be sold orally on the basis of rating and yield. It appears to me that pre-delivered information is most needed in situations involving new securities and asset-backed securities where the buyer frequently negotiates a final price based on the types of information provided in the envisioned term sheet. Some institutional buyers that I spoke with seem to agree with this focus. The industry should not find this requirement a burden because these are the offerings that they will need to pre-market anyway.
To address the second concern about last minute investors, a seven or three-day pre-delivery requirement would preclude someone who did not receive a preliminary prospectus from participating at the final moment. The question is whether a last minute investor is in need of less protection. I do not think so as a general matter. But, what if the Commission was to exempt accredited investors and institutional buyers? These buyers have already been determined to not need the same protections under the Securities Act of 1933 as they may in private placements. Thus, having disclosure provided to them the same day as the transaction would seem a fair compromise. Another solution is to provide a de minimis exception from the seven or three day requirement for up to five percent of the total offering. For example, if a company was offering to sell one million shares, it could provide same day disclosure for up to 50,000 shares. Industry representatives have told the staff that they rarely see more than five percent last minute buyers anyway. In each exception, the issuer or underwriter would still need to get the prospectus to the buyer before the investment decision so that investors would still be protected.
The last of the industry concerns about this proposal the consequences of failing to deliver could be addressed by making the pre-delivery obligation a part of Rule 15c2-8, rather than pursuant to Section 5(b) of the Securities Act. The Rule applies to broker-dealers only, so a parallel rule would be needed for issuers who may direct public offerings without underwriters. A failure to comply with the Rule allows the guilty party to be targeted, rather than all parties to the transaction, whereas a failure to comply with Section 5 can have broader consequences, including a possible recission offer. Investors will continue to be protected, as underwriters must comply with the Rule. Another approach might be to create a good faith safe harbor under Section 5 for unintentional and immaterial failures to pre-deliver the preliminary prospectus or term sheet.
3. Filing Transactional Information
Just as I believe investors benefit from timely delivery of prospectus information, so too do I believe that the market benefits from timely notification of a transaction. The most controversial proposal in this regard is the requirement that an issuer eligible to use shelf registration today would be required to file its Form B on the day of transaction, rather than file a prospectus supplement 48 hours after the transaction as is currently provided in shelf offerings. Critics have charged that, given the speed at which shelf takedowns occur, it is impossible to prepare and review the proposed Form B properly on the same day as the transaction. Given that the issuer would take strict liability for material misstatements in the Form, it appears to be in the market and investor interests to see that the Form is prepared carefully. Therefore, it seems that some compromise is appropriate.
I believe the market interest and Bar's concern can be satisfied by requiring a Form 8-K to be filed on the date of transaction that notifies the market about the transaction. This only should be required for larger transactions that cross a pre-determined threshold. The Form B, or a prospectus supplement, could then be filed two days later, consistent with current practice. The market would be notified promptly of significant transactions and the issuer would have sufficient time to prepare its filing. This seems like a simple solution.
4. Filing Written Communications
One of the most notable goals of the aircraft carrier is the proposed opening of communication under the Securities Act. Where companies today are restrained from speaking during so-called "quiet periods" and are precluded from using written sales literature other than the preliminary prospectus, the proposals would free companies and underwriters to make oral or written offers generally. Form B issuers would have free communication at all times and Form A issuers would have free communication but for a 30 day quiet period prior to filing its registration statement. In return for this flexibility, under proposed Rule 425, sellers would file any written selling materials with the Commission on the EDGAR system. This transparency would provide an incentive for sellers to be prudent in their claims and would address in part the issue of selective disclosure by ensuring that what is disclosed in writing to one investor is available to all.
While corporate and industry commenters supported added flexibility for communications, they argued that the filing requirement was too broad and would chill written communications. They especially worried about what it might mean for materials displayed at traditional road shows, as well as on-line road shows. In addition, they worried that an inadvertent failure to file one piece of written communication by one syndicate member would violate Section 5 for all.
Now that the Commission has adopted Regulation M-A, which includes the filing requirement, I think it will be a good test case for whether a filing requirement generally will chill written communications. It may be true that the incentive to publish written communications is greater in the business combination setting. Nevertheless, I think that issuers will get comfortable with the discipline that a filing requirement imposes and be less deterred from using written communications. The public policy benefit of addressing selective disclosure is too strong for the Commission to retreat here.
Road shows are a different matter. For decades, underwriters and issuers have conducted road shows across the country to meet and pitch securities to large investors. When these face-to-face meetings are oral communications, they have been permitted under the Securities Act. Over the years, it appears that these road shows may have included written handouts, slide show presentations, and other uses of technology that may suggest use of an illegal written prospectus. I am told that persons presenting a road show attempt to address this potential violation by making sure that all materials are collected before the meeting ends and therefore the information disseminated is more temporary in nature, similar to the reasoning behind the statute's special treatment of oral communication. In fact, when the issue of whether road shows could be performed on-line was raised, the Commission staff no-action letters granted relief where the road shows took special steps to make them more like oral communications (e.g. limited viewing opportunity, no substantive editing, and steps to make it otherwise similar to a face-to-face meeting). The use of Internet roadshows has undoubtedly saved millions of dollars in travel expense and a wealth of travel time for road show participants.
The issue raised by the aircraft carrier release is whether road show materials, or on-line road shows themselves, are a writing that should be filed with the Commission. On the one hand, information and projections provided at road shows are likely to be of great interest to investors and this type of information should not be provided selectively to large investors. On the other hand, given the sensitivity to liability for projections, it seems more likely that sellers would provide information in a manner that would not require filing. If on-line road shows are deemed writings required to be filed with the SEC, I think it is likely that sellers would return to the traditional face-to-face meetings. This would not stop selective disclosure and would have the unfortunate effect of curtailing the use of an efficient technology for providing information broadly.
As a policy matter, it seems to me that we should tailor a solution that recognizes current practice. The Bar appears to be comfortable in making judgments about whether something is a writing. If counsel believes road show material is a writing, it makes sense to have the writing filed with the SEC. The issue is not so clear with on-line road shows. I believe there is a middle road between filing and not filing an on-line road show. Sellers could be required to open their road shows to the general public (who were customers of one of the syndicate members) on an issuer or underwriter web site. The road show would not be filed with the Commission, but would stay up on the web site throughout the offering period and the post-offering prospectus delivery period. After that time, the sellers could remove it from the web site, but retain a copy for a specified time (like two years). It would not be part of the prospectus. This compromise would address selective disclosure in that retail investors would get to see the road show. It would also hold the sellers accountable because a copy of the program would be available if a question later arose regarding the falsity or misleading nature of some statement.
5. Secondary Shelf Registrations
For many years, issuers have been able to establish a shelf registration mechanism to register the resale of securities that were placed privately. In many cases today, private placements are conditioned on an issuer's promise that it will file a registration statement for the resale of the securities within a reasonably short period of time. There are usually substantial penalties for delay. This has led to the growth in so-called PIPE (private investment public equity) transactions.
The challenge with resale registration statements is that the issuer is never quite certain when the holders of the privately placed securities may resell into the market. Because of this, the registration statement would need to remain "evergreen" until the securities are resold. To facilitate issuers and the sellers, the Commission permits all issuers (including those who only qualify for Form S-1) to use Form S-3 that provides for "forward incorporation by reference" of any new information and periodic reports filed by the issuer. This is a very flexible mechanism for small companies especially.
Because issuers unable to qualify for Form S-3 on a primary basis could qualify for the Form on a secondary basis, there is a regulatory incentive for issuers to make transactions in two steps rather than one. The thought was to end this regulatory incentive and keep issuers on the same form regardless of whether they were selling directly or indirectly through conduits into the public markets. Arguably, investors need the same information about a company regardless of whether an issuer, or some holder of previously restricted securities, is the seller.
The problem with the aircraft carrier proposal is that it would mean that a Form A issuer possibly would have to update the disclosure each time a holder of the privately placed securities chose to sell. This would be difficult for an issuer to monitor, especially where there were many holders. If the Commission is worried about a possible abuse of a planned two step public sale, commenters argued, then there should be regulatory steps tailored to those abuses only.
There are several ways to focus regulatory attention on the possible abuse; some more popular than others. One approach would be to permit the use of Form B for secondary offerings of Form A issuers, but require a minimum time period (such as three months) to elapse subsequent to the private placement. Alternatively, these Forms B might be tagged so that they do not go effective automatically without staff review. The staff could then evaluate the transaction to determine if it truly relates to a secondary offering. Also, the imposed time delay would serve to demonstrate that there are really two transactions instead of one. The second alternative would remove some of the regulatory incentive for engaging in a two-step public financing (being able to avoid staff review). Neither of these conditions should prove fatal to today's non-abusive PIPE transactions as they already tend to take months to complete and there already exists a possibility of staff review. Therefore, it should be hard for commenters to complain.
Another possibility would be to keep PIPE resales on Form A, but permit forward incorporation by reference as long as the issuer was timely in its periodic reports. Thus, issuers would have a duty to inform the market timely, but would not have the burden of monitoring when each holder chooses to sell. This could accomplish the regulatory objective by removing the incentive for a two-step transaction without burdening small companies.
6. Exxon Capital Transactions
The Exxon Capital staff interpretive letters also creates a regulatory incentive to execute transactions in two steps rather than one. Here, an issuer privately places debt securities with qualified institutional buyers (QIBs) and then, rather than filing a secondary shelf registration statement, it registers an exchange offer of freely tradable securities for the restricted ones. In many cases, the company conducting the transaction is a private company planning to go public as part of the exchange offer. There are two other regulatory concerns. First, issuers are essentially registering a transaction that has already been completed. The buyers are the same and the securities are virtually the same. Second, the securities may be finding their way into the public markets without benefit of Securities Act protections.
The aircraft carrier proposed that offerings solely to QIBs could be conducted on Form B, which would eliminate the need for the Exxon Capital letters, except that it required that the issuer already be a public company. This would leave the letters still for that reason attractive to non-reporting issuers. Commenters generally expressed a desire to keep the letters.
After the proposals were published, the Dignity Partners case agreed with the SEC position that Section 11 liability attaches to protect persons who did not buy directly from the issuer. 2 Although this issue is not settled in all jurisdictions, this alleviates some of my concern. Second, a study performed at the request of Latham & Watkins provides evidence that most of these securities stay in institutional hands. Thus, our concern should be less than with secondary shelf transactions, which can be sold into the public markets. Last, only debt securities (and foreign equity) can use Exxon Capital. Debt offerings have different dynamics and raise different investor protection concerns.
As a result of the comfort gained after the proposals, I think there is a reasonable solution. The Commission could extend Form B to QIB-only offerings by non-reporting issuers, but only for debt. Debt is less likely to end up in retail investors' hands and so a quicker transaction without staff review may be warranted. Investors would get greater protection than they get today in Exxon Capital transactions.
7. Disqualifications for Certain Persons
Under the proposals, use of fast track Form B registration would be denied to issuers in two controversial circumstances: if an issuer, or underwriter had violated Section 5 or the anti-fraud provisions of the federal securities laws recently, or the Commission staff had issued comments on the issuer's Form 10-K and the issuer had yet to resolve those comments. The concern was that Form B has no staff review and may be employed by bad actors to avoid detection or to avoid responding to outstanding staff disclosure comments.
Historically, similar "bad boy" provisions have not been applied very often. This leads me to question their utility. Commission rules under Regulation A and Regulation D have similar disqualifiers, but the Commission often waives these disqualifiers in settlement negotiations. One significant problem is that major investment banks, especially those with affiliated retail brokerage activities, are often being cited for violations of the securities laws. Query whether one broker's violation in a remote regional office of a broker-dealer should disqualify all of that broker-dealer's customers from using Form B. A company like Microsoft or General Motors would be compelled to use Form A registration if it selected such a broker-dealer as its underwriter.
While I worry whether any disqualification provision can be practical, I can envision a more focused one. Perhaps another sanction could be established. For example, the Commission may choose to bar a person from being an officer or director, or can bar a regulated entity from the industry. If there were a streamlined procedure for the Commission, on a case-by-case basis, to determine when a defendant's conduct was suitably egregious that its public offerings should be reviewed by the Commission staff, then it could seek such a sanction as a part of its normal enforcement activities. Thus, it would take an affirmative step by the Commission to disqualify someone or an entity. Presumably this tool would be used sparingly in order to be effective.
As for the issuer disqualification relating to comments from the Commission staff, we are concerned that, without the possibility of staff review, companies will have less incentive to comply with comments on their Forms 10-K. Some commenters argue that it would be foolish for companies to ignore the comments of the Commission staff because they run the risk of Commission enforcement action and enhanced possibility of class action law suits. This, they argue, is the inherent leverage of Commission staff comments.
My suggested compromise would be as follows: Issuers would not be subject to disqualification until they receive a letter of comment from the staff. If a company has been selected for review, but no letter has been issued, the issuer could continue its use of Form B automatically. In the letter of comments, the staff would identify which comments were significant enough that a subsequent filing would be disqualified until the comment was resolved. This would create a case-by-case approach rather than an automatic disqualification. It would also build on the existing system of discussion back and forth between the staff and the issuer. Once the significant comments were deemed satisfied, an issuer would be free to proceed normally. Given that an issuer's Form 10-K is unlikely to be reviewed by the staff more than once every three to five years, this should not be a significant obstacle.
B. Other Issues
There are dozens of other issues that need to be addressed in the aircraft carrier, but I believe that I have addressed the big seven. The secondary issues can be resolved more easily. I fear that without seeking creative compromises to the big issues, the aircraft carrier is unlikely to move forward in one piece. These solutions should address practical concerns while preserving important investor protections.
III. Technology Compels Change
One of the catalysts for broad reform of the Securities Act is technology. The growth of the Internet has already forced the Commission to re-evaluate its regulatory scheme.
In response to these developments, the Commission has taken several major steps to keep pace with the changing markets by updating our rules and regulations and providing interpretive advice when necessary. Over the past four years the Commission has issued three interpretive releases addressing various securities law issues raised by the Internet and adopted rules regarding the use of electronic media to deliver information.3 In addition, vast amounts of information regarding public companies is widely accessible to the markets via the Commission's EDGAR system. The aircraft carrier proposals that I just discussed were one major step to attempt to integrate technological change with the regulatory framework. However, there are many other areas where change is ripe in the near future. Even the massive aircraft carrier release could not encompass them. Today I will address two areas that have attracted my notice. One is in the area of private placements under the federal securities laws and the other addresses the corporate law area of shareholder annual meetings.
A. General Solicitation in the Age of the Internet
The Internet has become a tremendous and cost effective tool for information dissemination. It is only natural that companies would desire to harness its potential in making public offerings. But what about private offerings? The Internet has far less utility here because of the prohibition against general solicitation.
The origins of the ban against broad solicitation of investors for purposes of making a private placement under Section 4(2) of the Securities Act date back to the first SEC interpretations in 1935.4 The Commission provided six factors to determine whether an offering is public or private. These factors were: (1) the number of offerees; (2) their relationship to one another; (3) their relationship to the issuer; (4) the number of securities offered; (5) the size of the offering; and (6) the manner of the offering. A broad solicitation of random investors that had no relationship with the issuer or each other was likely to be viewed as a public offer.
The Supreme Court addressed the application of Section 4(2) in the landmark Ralston Purina case.5 There, the Court focused more on the nature of the investors solicited. The decision stated that the application should turn upon "whether the particular class of persons affected needs the protection of the Act."6 The Commission later issued another interpretive release stating that "general solicitations of an unrestricted and unrelated group of prospective purchasers for the purpose of ascertaining who would be willing to accept an offer of securities is inconsistent with a claim that the transaction does not involve a public offering even though ultimately there may only be a few knowledgeable purchasers."7 Rule 146, addressing private placements, was adopted in 1974 with a ban against general solicitation. It was replaced by Regulation D, including Rule 502(c) which likewise bans general solicitation in private placements using its safe harbors. A number of court cases have been in harmony with the Commission's approach.
With these prohibitions, how does one use the Internet to engage in private placements? The answer is that a seller generally may not use the Internet to advertise for buyers any more than it can advertise in the Wall Street Journal to find buyers. Staff interpretive letters have made clear that such advertising is not appropriate as it would condition the market.8 A broker-dealer is permitted, however, to broadly solicit potential clients with the purpose of creating a list of potential eligible buyers in future private placements under Regulation D.9
When the staff was confronted recently with a question of whether a broker-dealer could use the Internet to solicit potential clients, it responded favorably with the proviso that the website be password-protected so that the general public could not see it.10 The boundaries of the permitted conduct continue to be tested with questions from practitioners.
There is a growing sentiment that the Commission should revisit its ban on general solicitation and general advertisement in light of the Internet and a more readily identifiable cadre of sophisticated investors. In fact, the Commission has created two exceptions from this ban for small offerings. First, Rule 504 of Regulation D permits general solicitation as long as state "blue sky" registration provisions are followed and the offering is less than $1 million. Second, the Commission adopted Regulation CE in 1996 to parallel a California blue sky exemption for offerings up to $5 million to sophisticated investors. General solicitation and advertising are permitted.
The question is whether there should be an exception for Rule 506 offerings. Under Rule 506, any amount of securities can be offered, but only to sophisticated investors. As long as only people not needing the protection of the Act are purchasers, some argue, why is there a need to prohibit a general announcement?
The factual scenario that is most relevant is where an issuer puts a notice in the newspaper or on the Internet stating that it is conducting a private placement of securities, but that the securities, by law, may only be offered to sophisticated investors meeting minimum net worth standards. The announcement then provides a contact number or email address, which will be used to determine whether a potential purchaser really is sophisticated or "accredited" for purposes of Regulation D. Currently, this would be viewed as a general solicitation. The question is should the disclaimer be given weight?
Disclaimers or legends are recognized under the securities laws. The so-called "red herring" legend that the preliminary prospectus is not a prospectus is important. Almost all 50 states recognize that if you advertise on the Internet but disclaim that you are not selling securities to their residents, and, in fact, do not sell to their residents, you have not made an illegal offering in that state. The Commission has used the same approach for offerings posted by foreign companies on their web sites. As long as foreign companies indicate that they are not offering securities to U.S. citizens and take reasonable steps to avoid selling to U.S. citizens, their Internet posting is not an offering in the United States subject to the registration requirements of the federal securities laws.11 Why then prohibit a company from posting a notice on its website that it is selling securities in a private placement as long as (1) it includes a warning that it will not sell to investors who do not meet the definition of accredited investor and (2) does not, in fact, sell to unsophisticated investors? Who is harmed?
The investor harm that I can see is presented by an unscrupulous seller who is really using the Internet posting to generate interest, or to build a potential buyer list, for a later planned public offering. I would be troubled by a private offering that is, in reality, a stalking horse for a soon to follow public offering. This is a sham that undermines Section 4(2) which may be avoided by imposing some conditions. For example, the Commission could state that keeping a list of potential buyers who turn out to fail the accredited investor definition is indicative of a sham private placement. Second, a safe harbor could provide that a public offer within a short period of time after the conclusion of the private offering (say 30 days) would be presumed to be part of the private offering (thus violating Section 5). The seller would have the burden of proving otherwise.
Because the Internet would provide a tremendous benefit, especially to small businesses, if it could be used to locate deep pocketed sophisticated investors recognized by the statute and the Supreme Court as not needing the same level of protection under the Act, I think the Commission will need to give this issue further thought. The Commission cannot have it both ways. Either meaningful disclaimers and legends have vitality under the federal securities laws or they do not. If they do, then a safe harbor for general solicitation in Rule 506 offerings is appropriate. The same can be true for other private placements under Section 4(2). In the end, it is hard to disregard the Supreme Court's focus on the status of the buyer rather than the manner of the offering.
B. The Annual Meeting in the Age of the Internet
The Commission is not alone in its need to amend its rules to keep up with the ever-changing demands of the markets. States have a similar need to review and amend their corporate laws. For example, Delaware and New York recently amended their state corporation laws to provide for electronic proxy authority, and many states have followed.12 Exchanges and Nasdaq also may need to amend their rules and companies will need to amend their charters and by-laws to address the continuing transformation of our markets in this new age.
One area in particular that I believe is ripe for transformation is the traditional annual meeting of shareholders. I am not the first person to target this area for change; many thoughtful commenters have been calling for significant change in the past five years, but now I can see real possibilities for transformation. Almost every public company today must hold an annual meeting as required by state corporation law and applicable exchange or NASDAQ rules. These meetings can be costly as well as time-consuming for both management and security holders. A typical annual meeting can cost anywhere from $20,000 to $100,000 dollars. Some of the larger companies with a broad security holder base can easily spend close to $1 million dollars after taking into account all the expenses of management time and resources, planning, scheduling, traveling, hotel accommodations, and other related expenses. Management often must begin planning for the next meeting shortly after the last meeting is over. As a result, the annual meeting is an ideal candidate for the application of new technologies that permit information to be communicated to a more representative shareholder base at a significantly reduced cost.
It is only a matter of time before the annual meeting is eventually transformed by the emergence of new technologies. Public companies such as Bell & Howell, Ford Motor Company, and Intel have already experimented with the Internet by supplementing their traditional meetings with a live simulcast on-line. Over the last few years these on-line meetings have drawn increasingly larger audiences. For example, Bell & Howell's first on-line annual meeting drew an audience of 200 in 1996 and approximately 1,800 the following year.13 Furthermore, companies such as Cisco Systems, Compaq Corporation, First Union, Hewlett-Packard and Pfizer have distributed their annual reports to shareholders electronically. It is clear that there is sufficient demand for use of the Internet. In one survey of on-line investors, 92% of the respondents indicated that they would more likely attend an annual meeting if it were available on the Internet.14
1. The Purpose of Annual Meetings
The conduct of annual shareholders meetings is a state corporate law matter. States typically provide only general guidance, which leaves the company with significant flexibility. State law generally requires that an annual meeting be held for the election of directors. The listing requirements of the various stock exchanges and the NASDAQ provide other matters for a shareholder vote. Since very few shareholders attend the annual meeting, most vote by giving a proxy to the company or a third party to vote in their place. The federal securities laws address the manner and form of proxy solicitation.
Over the years, with the increased interest in corporate governance, the annual meeting (and the company's proxy statement) has become more important as a vehicle for corporate accountability to shareholders. Proxy Rule 14a-8 provides a mechanism for shareholders to submit up to a 500-word proposal for a shareholder vote.
2. Today's Annual Meeting
Currently, the annual meeting is an event that can take several months of preparation using significant amounts of management resources. Senior management will often spend days if not weeks planning, rehearsing, preparing questions and answers, and drafting speeches. Despite all this work, I am told that the meeting will generally amount to nothing more than a mere formality because most of the larger, institutional investors will submit their votes ahead of time unless there is a particularly pressing issue outstanding. It is my understanding that the meetings are often not well attended and that employees often outnumber other shareholders. Generally refreshments are served and promotional items are distributed.
Some commentators have actually described the annual meeting as one of the "least useful rituals" in business and a "monumental waste of time and money"15 while others have characterized it as a "grand public relations event."16 Shareholder groups have told me that annual meetings are frustrating to them as well. They find management often unwilling to listen. Some shareholders accuse management of scheduling annual meetings in remote locations and at inconvenient times to discourage attendance. In any event, I believe that the annual shareholders' meeting can and will be improved through the use of new technologies becoming available. Given that both sides question the utility of today's annual meeting, I suspect there is growing support for a new model.
3. Evolution Towards an On-line Model
My view is that regulators, companies, and shareholders should begin now to move to an on-line annual meeting, not to augment, but to ultimately replace the existing meeting. I believe that there are four steps to an on-line meeting and that we have already accomplished two of the steps. The first step is posting meeting materials on-line. The second is to provide an on-line adjunct to the annual meeting. The third step is to transition into teleconferencing. And the last step is to create a cyber substitute. The state law obviously would need to change to allow this to happen.
The first step was facilitated by the 1990 change in Delaware law that validated electronic proxies. In 1995, the Commission published its electronic delivery interpretive release that permitted electronic delivery of all company materials. In the last few years, the subsidiary of ADP Corporation that processes proxy voting by shareholders who hold their shares in "street name" (i.e. in the name of their broker-dealer for convenience sake) has finalized an efficient mechanism for proxy voting electronically and through the Internet. It is now becoming more common for companies to place annual reports and other shareholder related information on their web sites. In my opinion, there is no legal impediment to prevent further expansion.
I have already cited several companies that have taken the second step of providing an on-line component of the annual meeting. I believe it is important for other companies to follow the pioneers in this area because it will condition shareholders to be more comfortable with remote participation in annual meetings. Again, there should be no legal impediment to this expansion. It is my sense that many companies do not see the utility of permitting on-line access, but I think that if they look down the road at the possibility of a more efficient, effective, and low cost alternative, perhaps they will be incentivized.
The third step is a natural offshoot of the second. The most difficult obstacle to an on-line alternative is that not all shareholders have access to the Internet. Recent studies indicate that a majority of households in the U.S. still have yet to subscribe to an Internet service provider. I suspect, however, that a majority of households that contain at least one shareholder have Internet access. The growing popularity of on-line trading will accelerate growth. The problem is what to do until Internet access becomes as common as telephone access. Regulators will be hard-pressed to let companies dispense with the physical annual meeting without some demonstration that the "cyber" meeting is accessible to all.
I find it somewhat ironic that an annual meeting on the Internet would be viewed as inaccessible when most every public library in this country has free Internet access, yet a physical meeting during a weekday in Wilmington, Delaware is viewed as accessible to all. Presumably, a shareholder could spend hundreds of dollars on airfare and a hotel room to attend the annual meeting from afar and that is deemed fair, but ask a shareholder to go to her local library or to pay less than $100 to rent a computer with Internet access, and that is deemed unfair. To satisfy those who are not quite ready for the new millennium I suggest that a company test the notion of using either an Internet transmission or videoconferencing capabilities to transmit the annual meeting live to a few select sites across the country. While I have not researched the precise costs of such an arrangement, I suspect that a local university, library, chamber of commerce, or other civic-minded establishment might make a room and screen available at modest cost for area shareholders to attend. For example, a company would hold its annual meeting in Wilmington, but would arrange to have a room available in each time zone (e.g. Chicago, Denver, and Los Angeles) where area investors could come and observe and participate in the Wilmington meeting. This would be a public service to its shareholders and condition them to accept remote access.
Since companies are cost driven, there needs to be a cost savings to encourage innovation. To do this, I envision that shortly after a pilot program companies get comfort from the state, or a declaratory judgment from a court, that as long as the company is providing reasonable access and real live participation opportunities for its shareholders that it can dispense with the Wilmington component in my example. Instead, the company's management and directors would be in a sound studio or corporate headquarters. Overall, I suspect that this would result in cost savings over the existing model, without any loss of access or accountability to shareholders.
The fourth step is potentially the most intriguing. It will permit the elimination and cost savings of no longer needing remote sites in multiple cities. Instead, once Internet penetration into the shareholder universe is sufficient, a company could conduct its business exclusively on-line. I am mindful that this will make the meetings less personal and potentially less attractive to some shareholder advocates. In return, I suggest that the company create a shareholder's forum and bulletin board on their website. Not only would this provide an easy mechanism for distributing information to shareholders, but I believe that this could eventually permit shareholders an official mechanism to speak with one another and post shareholder proposals for consideration. Companies would benefit from cost savings, an ability to see what the shareholders are saying to each other about the company, and more control over the process than they have monitoring a host of independent Internet "chat rooms." Clearly there is investor demand for chat sites, the question is whether it is better for the companies and their shareholders that it be the companies that supply the sites. Investors would benefit from having low cost access to meetings and other shareholders. I have spoken with some shareholders about this as an approach and they seem supportive.
4. Legal Considerations
Of course, there are a few legal issues that must be addressed before the annual meeting can be moved out of company headquarters or the expensive conference room and into the virtual world of the Internet or some other electronic communications media. First, shareholders will need to be able to cast their votes electronically, either over the Internet or from the remote viewing location. As I noted earlier, this is becoming accepted legally and is becoming more practical. Second, there is the state law requirement that the annual meeting occur at a specific "time and place." An Internet website may not constitute a "place" for purposes of state law, but I would expect that to become clearer. In fact, I understand that almost all states follow the Model Business Corporation Act that permits the bylaws to establish the place of meeting. Indiana, Michigan, Minnesota and Washington expressly permit shareholders to attend annual meetings via a conference call. Third, companies will need to consider how they will satisfy the quorum necessary to hold a valid meeting under state law. Many states' quorum requirements are based on the number of shares represented in person or by proxy and entitled to vote at the meeting.17 An argument can be made that a shareholder attending a meeting electronically is not "present in person" at the meeting and therefore would not be counted for quorum purposes. For example, at Bell & Howell's 1996 annual meeting, shareholders who watched the meeting on the Internet were not considered "present" for quorum or voting purposes. Nevertheless, it may be that the quorum requirement can be satisfied simply by attaining a sufficient number of proxies in advance of the meeting. Many of the other issues regarding electronic voting are being resolved.
As for the costs of holding two annual meetings, live and electronic at the same time, there could be some overlap for a period of time. The sooner accommodations are made for these new technologies, however, the sooner companies will be able the convert the traditional annual meeting to the electronic meeting. At that time, companies will be able to realize the full savings potential and investors will be better served by access to more information on a timely basis. In the long run, the electronic meeting should enhance investor relations, increase shareholder participation and reduce the unnecessary costs associated with holding a live meeting. The technology is there, and it is now up to our companies, the SEC, the states and the exchanges to act to make it all happen.
All views expressed in this speech are those of its author. These remarks in no way represent the views of the Commission or its staff. I would like to acknowledge the assistance of Jim Moloney, Special Counsel, for his research and contributions to the discussion of technology and annual meetings.
2Hertzberg v. Dignity Partners, Inc., 191 F.3d 1076 (9th Cir. 1999).
Securities Act Release No. 7233 (October 6, 1995); Securities Act Release No. 7288 (May 9, 1996); Securities Act Release No. 7289 (May 9, 1996); and Securities Act Release No. 7516 (Mar. 23, 1998).
Securities Act Release No. 285 (Jan. 24, 1935).
5SEC v. Ralston Purina Co., 346 U.S. 119 (1953).
6Id. at 125.
Securities Act Release 4552 (Nov. 6, 1962).
8E.g., Gerald F. Gerstenfeld (avail. Dec. 3, 1985).
9Bateman Eichler, Hill Richards Inc. (avail. Dec. 3, 1985).
10IPO Net (July 23, 1996); see also Lamp Technologies (May 29, 1997).
Securities Act Release No. 7516 (March 23, 1998).
Delaware amended its corporation laws in 1990 to validate electronic proxies, including those send via facsimile. See DGCL Section 212 (c) and (d). [Cite to NYBCL].
Sebastian, Cyber-Proxies and On-line Annual Meetings Gain More Ground, Wall St. J., April 16, 1998, at A1.
14Internet Annual Reports Are Read Carefully, Despite Impressions Investor Relations Business (Sept. 16, 1996) reporting the results of an on-line survey performed by the investor relations firm of Rein-Nomm & Associates.
Philip R. Lochner, Jr. and Richard H. Koppes, Stop Us Before We Meet Again, Wall St. J., Mar. 18, 1994 at A10 (former SEC Commissioner Philip Lochner and CalPERS General Counsel Richard Koppes commenting on the usefulness of the annual meeting today).
Chancellor William T. Allen of the Delaware Court of Chancery in Hoschett v. TSI International Software, Ltd., C.A. No. 14601, (July 19, 1996).
For example, see DGCL Section 211(c).