U.S. Securities and Exchange Commission
Report to the Congress:
The Impact of Recent Technological Advances on the Securities Markets
Section 510(a) of the National Securities Markets Improvement Act of 1996 directed the Commission to study and report to Congress on the impact of technological advances on the securities markets. Pursuant to that provision, this report discusses the impact of recent technological advances on the securities markets, how these advances have changed the way the markets operate, and steps the Commission has taken to address these changes. The use of new technologies at this time varies considerably in nature and scope among different segments of the industry, and the report separately addresses the current trends in technology use by public companies, the mutual fund industry, investment advisers, and the secondary markets. Finally, the report discusses the effect of recent technological advances on enforcement of the federal securities laws.
The Securities and Exchange Commission has principal responsibility for the administration and enforcement of the federal securities laws. Section 510(a) of the National Securities Markets Improvement Act of 1996 1 directed the Commission to study and report to Congress within one year on the impact of technological advances on the securities markets. 2
Information and communications technologies are critical to healthy and efficient primary and secondary markets. Indeed, under the federal securities laws, disclosure and dissemination requirements are crucial elements of the Commission's approach to protecting investors and promoting fair and orderly markets. The Commission has long recognized the benefits of information and communication technologies in furthering these goals.
While the markets have always quickly assimilated technological advances that increase market efficiencies and enhance information flow, the recent pace of development has accelerated. In the last decade, such tools as personal computers, desktop workstations, networking capabilities, more powerful computer processing and increasingly sophisticated hardware and software have been developed and made commercially available.3 These recent advances in information and communications technology are resulting in markets that are more efficient and transparent and better able to handle increased trading volume. In these respects, the impact of new technologies upon the securities industry as a whole has been pervasive. Moreover, the benefits of recent technological developments have not been limited to the markets, but extend to all securities industry professionals.
The future impact of continuing technological advance is far-reaching. 4 Already, an individual investor with a computer and a modem has unprecedented access to information. Information and communication technologies such as the Internet may ultimately significantly affect the ways in which investors interact in our markets. 5 Various industry participants have been offering both retail and institutional investors the opportunity to transact business on-line. On the other hand, although there have been numerous experiments in the on-line world, the vast majority of securities transactions still occur in traditional ways. This may be because the technologies that will ultimately allow realization of these benefits are developing and changing. Until new technologies coalesce around uniform standards, and until consumers and investors generally accept new technologies as safe and effective ways of doing business, the potential benefits will not be fully realized.
Because of the continuing stream of advances in the information technology industry and the rapid pace of implementation by industry participants, this report can only provide a snapshot of the impact of technological advances on the markets. As detailed in the body of this report, the use of new technologies at this time varies considerably in nature and scope among different segments of the industry.
Because of the central role of technology in the securities markets, the Commission's regulations have always had to take into account the state of technology in the industry. The Commission has issued interpretive releases making clear that electronic media, including the Internet, may be used to satisfy statutory delivery requirements and has provided extensive guidance on using these media for effective delivery. The Commission staff has issued numerous no-action and interpretive letters and has provided informal guidance to facilitate compliance with securities law requirements by users of novel applications of new technologies. The staff has also acted to clarify the application of existing legal requirements to securities products or services made possible by new technology. In addition, the staff has underway major initiatives to review fundamental elements of the regulatory structure governing public offerings under the Securities Act of 1933, and of the regulatory structure governing securities markets under the Securities Exchange Act of 1934.
Consistent with these efforts, the Commission has been sensitive to the regulatory challenges of a changing technological environment. It has sought to balance the benefits of encouraging innovation and the use of new technologies against the need to protect investors and maintain orderly markets. For example, while the Commission has permitted electronic delivery of required documents, it remains committed to protecting all investors, including those who do not have access to, or do not choose to use, new technologies. The Commission has acted to encourage such beneficial products and services, while also aggressively seeking to ensure that new technologies, and particularly the Internet, do not become new media for fraud and abuse.
As the Commission moves forward to implement the goals of the federal securities laws, it will be important to keep abreast of changing technologies and developments in related areas of the law. As information and communication technologies mature and gain more widespread market acceptance, the Commission will need to continue to work closely with other governmental regulators, industry participants and technical specialists.
Recent technological advances have offered unprecedented opportunities to public companies and investors alike. This chapter will discuss the regulatory framework, the current practices, and the Commission's approach to these developments as they relate to capital-raising, as well as to companies' disclosure of information to their investors and the trading markets at large. 6
Information is at the heart of the federal regulatory framework for protecting investors. It rests on the premise that an investor can make a reasoned decision on whether to buy, sell or hold securities, or how to vote on corporate matters, if the investor has full and accurate information -- about the company, its business and financial condition, the security it is selling, and any merger, tender offer or other transaction in which it is engaged.
As early as 1984, the Commission recognized the value of having information required by the federal securities laws available in electronic format, when it instituted a pilot program for electronic filing with the Commission. Today, most domestic companies make their filings in electronic format on the Commission's EDGAR (Electronic Data Gathering, Analysis, and Retrieval) system. The ready access to this database made possible by the Internet, both through the Commission's own web site and other sources, forms the core of a new body of corporate information now available on-line.
Public companies and other market participants are also using electronic media to communicate directly with their shareholders and potential investors. While the Internet is the most widely used technology for this purpose, experimentation with other electronic technology has also begun. The use of these technologies to disseminate information provides numerous benefits to companies and other market participants, such as:
To enable the use of developing technologies, the Commission has engaged in several initiatives. The Commission's October 1995 interpretive release provided guidance for market participants on using electronic media to satisfy delivery obligations of disclosure documents. The Commission staff also has provided interpretive guidance or no-action relief in certain regulated areas where market participants have presented novel and innovative applications of technology to market practices. The Commission staff also addresses electronic issues on a case by case basis as they are raised by market participants.
As technologies continue to develop, the regulatory framework must evolve as well. The Commission began an initiative to reexamine basic federal securities law principles that have existed for over 60 years -- since the creation of the Securities Act of 1933. This reexamination is partially driven by the impact of recent technological advances. In July 1996, the Commission published a concept release on Securities Act registration and disclosure reform which sought comment from the public about broad reform of the capital formation regulatory framework. 7 The Commission's regulatory authority, including the exemptive authority in the National Securities Markets Improvement Act of 1996, will allow the federal securities law framework to keep abreast of -- and realize the potential benefits of -- technological developments.
B. Regulation of Securities Offerings, Public Company Disclosure and Communications
The Securities Act of 1933 and the Securities Exchange Act of 1934 are premised on the philosophy that investors are best protected in making investment decisions if they are presented with full and accurate disclosure of all material information about investments. Under some circumstances, the requirements focus on preventing premature or inappropriate disclosure, while under other circumstances, the requirements focus merely on establishing minimum standards of disclosure. In some cases, this information must be delivered directly to the investor, while in other cases, the information need only be filed with the Commission and made public, so that the entire investing public has access to it. Because communication of information is such a central concept under these laws, the following discussion provides highlights of the regulatory framework to provide a basis for assessing the impact of trends in the use of electronic media.
1. Public Offerings
The Securities Act establishes a framework for providing information during a securities offering, requiring that issuers provide investors with material information concerning securities offered for public sale. Before a company may offer a security to investors, the Securities Act requires that the security either be registered with the Commission or that the transaction or security be entitled to an exemption from registration. The Securities Act applies both to initial public offerings and to subsequent public offerings.8
The Securities Act controls the timing and content of disclosures made by issuers in their registered offerings of securities to investors by dividing the process into three time periods: pre-filing, waiting and post-effective. Different limitations apply to disclosure of information in each period.
The pre-filing period is when an issuer contemplates conducting a public offering but has not yet filed a registration statement with the Commission. 9 During the pre-filing period, the Securities Act imposes restrictions on activity that could condition the market for the securities.
Once a registration statement is filed with the Commission, 10 the waiting period begins. During the waiting period, while the Commission staff is processing the registration statement, only oral communications and distribution of the preliminary prospectus included in the registration statement (also known as a "red herring") are permitted. No other written material generally may be distributed and no sales of securities may be made.
After the Commission declares the registration statement "effective," issuers may complete their offerings. 11 During the post-effective period, issuers may use written sales literature (in addition to the prospectus) to sell securities, as long as a final prospectus is sent before or with the sales literature. To complete a securities sale, a final prospectus must be delivered to all purchasers before or with the sales confirmation. In initial public offerings, a preliminary prospectus also must be sent to investors 48 hours before delivering the sales confirmation.
Certain securities and transactions are exempt from registration with the Commission. One example is private offerings limited to persons who have access to the type of information that registration would disclose and who do not propose to redistribute the securities. No general solicitation or advertising is permitted in a private offering. Other offerings may be exempt from registration if they do not exceed a certain amount, such as offerings by private companies not exceeding $1 million annually. 12 In addition, Regulation A provides a conditional exemption for certain small offerings of up to $5 million. 13 Even if the security or offering is exempt from registration, the anti-fraud provisions still apply to the sales of all securities.
2. Disclosure and Communications
The Exchange Act establishes on-going periodic reporting and disclosure requirements for public companies. The Exchange Act governs over 15,000 publicly held companies, helping to ensure well-informed securities markets for a diverse group of issuers in every industry, from large multi-national companies to small businesses. The Exchange Act requires public companies to periodically file certain information with the Commission and, in certain cases, to deliver the information to security holders. This information, such as annual and quarterly reports, is available to the public regardless of whether there is an obligation to deliver these documents to investors.
In addition, under the Exchange Act, public companies and other persons who solicit proxy votes from shareholders must file with the Commission and deliver to shareholders a proxy statement containing specified information and a proxy card. 14 While the Commission's proxy rules govern the disclosure that must be provided to shareholders by soliciting parties and the procedures under which proxies may be solicited, state law primarily dictates which shareholders are entitled to vote and, in combination with the rules of the stock exchanges and Nasdaq, what they are entitled to vote on. Companies also must send their shareholders an annual report before or with the proxy statement delivered in connection with any shareholders' meeting at which directors are elected. 15
Under the Commission's rules, shareholders may submit proposals to be included in the company's proxy solicitation material. 16 The Commission's rules also address the ability of shareholders to communicate with each other and whether that communication is a solicitation that requires the filing of proxy materials. 17 If a vote on corporate control is involved, each party soliciting votes must file proxy solicitation materials. If control of a public company is sought through a tender offer or other planned acquisition of over 5% of a company's common stock, certain reporting and disclosure obligations arise. The purpose of these requirements is to assist investors to make informed decisions on takeover bids. Other provisions supplement the disclosure requirements to help ensure investor protection in tender offers.
3. Regulatory Framework for Electronic Delivery
Against the background of a regulatory scheme premised on the dissemination of information, the Commission has recognized the potential of new developments in electronic communications to further the availability of information to investors. It has attempted to encourage the use of new technology by market participants to deliver information as long as investor protection is maintained, by providing a flexible broad framework for analyzing electronic delivery issues. This section briefly describes that framework in order to provide context for the discussion of current market trends in Part IV.
The Commission issued an interpretive release on electronic delivery in October 1995. 18 The release allows the use of electronic media and equates information delivered by this means to information delivered in paper. 19 The release makes clear that it addresses only the procedural aspects of delivery, and does not change the circumstances under which delivery of information is required. Securities law liability provisions apply to electronic delivery just as they apply to paper delivery.
Although the use of the Internet and other technology to disseminate certain types of business and financial information is rapidly growing, it is important to recognize that not all investors have access to computers. Of those who do, not all have access to external databases or desire to receive their financial information in that manner. Accordingly, the Commission's October 1995 Release explains that its approach is to maintain a level playing field for investors who use electronic technology and those who remain with the traditional paper-based system. In general, companies making use of electronic media also must provide paper copies when investors want them. This policy may evolve as electronic media become more universally accepted and accessible.
The release establishes a broad framework under which market participants can use electronic media to satisfy their delivery requirements. These media include not only the Internet but also audiotapes, videotapes, facsimiles, CD-ROM, electronic mail, and proprietary computer networks. Three basic guidelines are set forth: notice, access, and evidence of delivery. Although not exclusive factors, the release stresses that these factors must be considered to determine whether delivery requirements have been satisfied. The release provides over 50 examples applying the framework to specific facts. 20
Those providing electronic delivery should consider the extent to which such delivery provides timely and adequate notice. Postal mail delivery typically makes an investor aware that new information exists. As with paper delivery, postal mail delivery of information in electronic form, such as a CD-ROM, is sufficient notice. A web site posting of a document by itself, however, does not constitute notice. Separate notice for passive delivery systems, such as the Internet, is required unless the company can otherwise show that delivery has been effected. Separate notice can be made by e-mail or postal mail.
Access to electronic communication should be comparable to that provided by postal mail. Recognizing the wide disparity in investor abilities to use electronic media, the Commission has required that an electronic medium not be so burdensome that access is effectively denied. In addition, for as long as the applicable delivery requirements dictate, the investor should have the ability to retain or have on-going access to the document.
Those providing electronic delivery should have reasonable assurance that the investor received the information. This principle ensures that a market participant is not relying on electronic delivery to an investor who is unable or unwilling to take advantage of it. The release lists five nonexclusive types of electronic delivery evidence. For web site viewers, the evidence likely will be revocable informed consents, coupled with notice and access assurances. For consents to be considered "informed," they generally must specify the medium of delivery and the period during which the consent is effective. The consent should also specify the information that will be delivered electronically and inform the viewer of any potential costs associated with web site delivery.
Delivery evidence also may consist of an e-mail return receipt or other confirmation of an investor's accessing, downloading and printing the document. If documents are disseminated through facsimile, delivery may be presumed. Other forms of evidence include an investor's accessing a required document by hyperlink or using forms available only by accessing a document.
The Commission has also provided guidance for those who use technological innovations in exempt offerings. For exempt private offerings, the use of the Internet poses difficult general solicitation issues. Under these exemptions, general solicitation is restricted to ensure the offering is private. Unless there are methods to restrict access solely to investors qualified to participate in a private offering, an on-line offering under these exemptions likely would violate the general solicitation restrictions. Sensitive to the benefits of electronic delivery in private offerings, the staff of the Division of Corporation Finance has issued letters to clarify how these offerings can be conducted on-line without violating the general solicitation restrictions. 21 For exempt limited offerings, where general solicitation is permitted (including small business offerings made under Regulation A), these constraints are not present. 22
Although public companies and other market participants are taking advantage of technology for other purposes, they have been slow to change the methods by which they satisfy their regulatory obligations under the securities laws. In trying to do so, they may need to address regulatory issues of first impression. While the Commission has provided guidance on these matters, market participants also need to satisfy state securities and corporate law requirements, as well as rules of self-regulatory organizations. Some companies, particularly those in technology industries, believe the use of electronic media will appeal to their investor base, while others are less willing to devote time and resources to developing new means of communication with investors, particularly if it has limited and sporadic application.
In addition, investors are very diverse in their needs and wishes. Some take full advantage of electronic sources of information to aid them in their investment and voting decisions, while others prefer traditional (paper-based) methods of receiving information. Companies that want to use electronic media for delivery of information realize that they cannot ignore the needs of a large portion of their investor base. Over time, this may become less of an issue.
The past year has been a year of "firsts." The first multimedia prospectuses for public offerings were disseminated both on the Internet and on a CD-ROM. For the first time, several major companies provided annual reports and proxy statements on-line to meet delivery obligations to shareholders who consented to obtain them in that medium. The first Internet voting system was established and used by registered shareholders of several companies. Although it is too early to tell, these "firsts" may pave the way for increasing use of electronic media in satisfying regulatory obligations.
Perhaps the most significant technological development relating to public company disclosure is the on-line availability of the mandated electronic filing disclosure database, EDGAR. This dramatically improves the market's access to corporate disclosure. With this electronic filing disclosure database now available on the Commission's web site, access to corporate disclosure documents is no longer difficult for a rapidly growing number of investors. Since the September 1995 posting of the EDGAR database, the web site has been "hit" more than 100 million times. Daily, the web site typically is "hit" half a million times and approximately 2.5 million pages of text are downloaded. 23
The Commission has made it clear that issuers and underwriters may use web site prospectuses to satisfy delivery obligations if appropriate notice and access are
In May 1996, a major investment bank was the first to create a web site devoted exclusively to a corporate securities offering. 26 The web site included the textual preliminary prospectus and a list of participating brokers. In mid-1996, another highly publicized offering featured a web site prospectus. 27 For both of these offerings, a web site was created exclusively for the prospectus. 28 Since September 1996, a major public company has been offering its debt securities on-line. 29 The web site prospectus was not used to satisfy delivery requirements in these offerings.
Internet technological advances are affecting the look and sound of web site prospectuses. In May 1997, the first web site prospectus with audio and video components was posted. Audio is provided by "streaming." 30 Video is downloadable. The web site prospectus consisted of textual disclosure, a product overview with text, photographs, and audio, and a downloadable video with product demonstrations. The paper prospectus, used to satisfy delivery obligations, contained an appendix with an audio script and pictures from the video.
Breaking new ground in two limited contexts, issuers seeking to raise capital directly are beginning to use web site prospectus delivery. These issuers are raising capital on-line by two offering types: Internet direct public offerings and direct stock purchase plans. A direct public offering ("DPO") is an offering made without a professional underwriter. Since the 1995 much publicized Spring Street Brewery on-line initial public offering, commentators speculate that several hundred DPOs may have been offered. 31 DPOs typically are made by small businesses in limited offerings. 32 The actual number of on-line DPOs is difficult to determine since many DPOs are made in offerings that are not required to be registered under the Securities Act. 33 Many of these do not require the filing of an offering document with the Commission. A sizable percentage of DPOs, however, are Regulation A offerings, 34 and a few are registered offerings, both of which require filing an offering document with the Commission.
Larger, established public companies are making their first on-line foray into direct offerings through their direct stock purchase plans, which provide a vehicle for investors to purchase stock on a periodic basis. Compared to a handful in 1994, now more than 300 public companies offer direct stock purchase plans. On-line access to direct stock purchase plan prospectuses and enrollment forms is the latest development, which some commentators expect to grow quickly. 35
A growing number of major public companies are implementing "self-service" employee benefit systems, including those that offer company stock as a part of the benefits package. 36 These systems allow employees to access information regarding their company benefits, such as 401(k) plans, through various media. One popular system, the voice response system, allows employees to use their touch tone telephones to quickly obtain account information, such as balances, and may also offer full transaction capabilities. 37 More recently, employers have been beginning to consider using intranets to assist their employees in managing their accounts. 38 An intranet, an in-house version of the Internet where only company employees have access, allows employees to access their benefits information and conduct transactions on their personal computers. 39
Public companies also are beginning to make use of electronic communication to offer securities by providing CD-ROM prospectuses. In February 1997, a company delivered the first multimedia CD-ROM prospectus to all offerees in its public offering. 40 The preliminary and final prospectuses consisted of two separate types of media: paper and CD-ROM. The CD-ROM contained both textual disclosure and a video presentation by the company's management that focused on the company's business. Since that time, additional CD-ROM prospectuses have been delivered in public offerings. 41
The growth of complex financing techniques has been facilitated by the use of computers to analyze complex and large amounts of data. For example, unlike traditional corporate debt whose value depends partly on the creditworthiness of the issuer, the value of asset-backed securities principally is determined by the cash flow attributes of the numerous assets underlying the security. To determine whether to invest in these more complex securities, investors evaluate the impact of alternative potential future cash flows to assess the security's yield. This requires complex calculations on the cash flow attributes of the numerous assets underlying the security. To enable investors to make an informed investment decision, some asset-backed securities issuers are delivering computer disks that contain tabular data so that investors can use the data in their own computerized financial models. These computer disks are part of the prospectus. 42 The data enables the investors to make predictions of the future cash flow of the assets placed in the pool to determine the value of the security. 43
For many offerings, an issuer's management and its underwriters engage in a direct selling effort to targeted investors. This selling effort, known as a "roadshow," typically is a presentation by an issuer's management made to a relatively small group of sophisticated investors or on a one-on-one basis. Most roadshows are conducted during the waiting period when written communications are restricted. 44 Due to the expense of staging a roadshow in many cities, the demands on the targeted investors by multiple issuers, and the limited time available for an issuer to conduct a roadshow, market participants have been exploring whether roadshows could be provided electronically to investors. Several entities, which have received or requested no-action relief, recently announced plans to provide electronic roadshow services for issuers and underwriters. 45
Sales literature is any written material provided to investors after the registration statement is effective, not including prospectuses or tombstone advertisements. 46 The Commission's release provides that sales literature can be provided on-line as long as certain procedures are followed to ensure that an investor has access to the final prospectus. For example, sales literature can be in close proximity on the same menu as the web site prospectus or hyperlinked to the final prospectus. 47 To date, it appears that a limited number of issuers, most of whom are DPO issuers, are posting sales literature on their web sites.
Due to limits on a company's ability to engage in general solicitation of potential investors during a private offering, the Internet is not an easy medium to use in private offerings. With Commission staff guidance, issuers are beginning to develop web sites with password protection that enable qualified investors to view private placements on-line. 48 Although difficult to determine, it is believed that only a few private offerings have been made on-line to date.
Many public companies believe that Internet technology offers a valuable forum for communicating with current and potential shareholders. 49 According to a National Investor Relations Institute ("NIRI") survey, over 95% of companies with over $1.5 billion in market capitalization, and over 75% of companies with under $1.5 billion in market capitalization, either already have or soon plan to establish a web site. Placing a company's web site address in advertisements is now commonplace.
The Commission has not regulated web site content any differently than any other medium's content. Companies are not required to notify the Commission when a web site is created. Nor must a company file web site content with the Commission solely because it is on a web site. As for any other medium, anti-fraud laws can apply to web site content. 50 Any postings that may "condition the market" before a registration statement is filed for an offering may be illegal "gun jumping."
Disseminating corporate information appears to be one of the more popular uses of a public company's web site. 51 Over three-quarters of corporate web sites post financial information usually in the form of quarterly press releases or periodic reports, including annual reports, Forms 10-K, and Forms 10-Q. 52 The sites either hyperlink to the company's filings in the EDGAR Internet database or directly post reports. 53 On-line access to this information may reduce the company's printing and mailing costs. Investors may have the ability to search more easily within a document, hyperlink to recent nonfinancial news, and learn about complex matters through the use of hyperlinks to educational material.
Many web site annual reports have enhanced features. 54 Under the Commission's interpretive guidance, a web site annual report may contain information not included in the paper version of the report. Recent annual reports have included video presentations by senior management, and interactive applications to enable investor feedback. Some annual reports provide spreadsheets that permit the viewer to analyze the company's financial data. 55
Annual reports on a CD-ROM can employ search tools and display video and audio information. One obstacle to using CD-ROM annual reports is the cost for production, engineering and mailing a CD-ROM. Although CD-ROM annual reports were first used five years ago, companies have been slow to embrace this medium. 56 The ability of web sites to provide audio and graphics to a broader audience may stall any further growth in CD-ROM annual report use. 57
The delivery of proxy material is somewhat complicated by two factors: (a) state law normally gives only record holders, and not beneficial owners, the right to vote; and (b) the majority of the stock of public companies today is held by record holders, typically broker-dealers and banks, in "street-name" and companies may not know the identity of many of their beneficial owners, typically individual and institutional investors. 58 Because the record holders therefore have the right to vote street-name stock, under the laws of most states, they must either seek voting instructions from the beneficial owners or "pass through" the vote to these owners by giving them a signed proxy. 59
The Commission's proxy rules provide a mechanism for delivery of annual reports, proxy statements and forms of proxy by requiring bank and broker-dealer intermediaries to forward these documents to the ultimate beneficial owners. 60 Many broker-dealers and banks use a proxy intermediary firm, Automated Data Processing, Inc.'s Investor Communications Services ("ADP"), as their agent to comply with this requirement. Generally, ADP mails these materials in paper form. Also acting as agent for brokers and banks, ADP receives voting instructions electronically from those institutional investors that use ADP's Proxy Edge Service, and sends an omnibus ballot to companies.
Direct registration of securities enables companies to know their shareholders' identity. 61 Under the supervision of the Commission, in November 1996, the nation's largest clearing agency and securities depository, The Depository Trust Company, established a pilot direct registration program in cooperation with issuers, broker-dealers and bank record holders. 62 Participating shareholders voluntarily are able to have their shares registered in book-entry form directly on the books of the issuer. These shareholders receive a statement of ownership in lieu of a securities certificate (although they can get a certificate upon request). These shareholders also receive proxy materials directly from the issuer and can vote their shares without having to interact with an intermediary, subject to state law requirements.
During the 1997 proxy season, several public companies offered electronic delivery of proxy statements and annual reports to their record holders for the first time. 63 One large company allowed its record holders to choose among three forms of delivery for its annual report: paper, CD-ROM and the company's web site. 64 Another large company offered its record holders the opportunity to receive web site delivery of its proxy statement and annual report, pursuant to a notice and request for consent mailed to these holders. Those record holders who returned a consent then received another notice by mail notifying them of the web site address and availability of the annual report and proxy statement. 65
The fastest growing audience for electronic proxy material and annual report distribution is employee stockholders. 66 The reasons for the growth are that an employer's intranet or e-mail system makes the notice more secure and the company is more capable of recognizing and solving computer access problems for employees than for non-employees. In addition, a company providing access to electronic media can presume that employees will accept electronic delivery unless they request paper. 67 Typically, notice of the proxy solicitation materials' availability is sent by e-mail to the employees and the materials are posted on the employer's web site. 68
Many institutional investors that hold shares through banks and brokers have been electronically providing voting instructions through the ADP Investor Communications' Proxy Edge System. 69 ADP's Proxy Edge is a software package that manages the proxy process for institutional investors in a variety of ways. By the end of 1997, ADP hopes to have an Internet voting system available.
State law governs whether on-line or telephonic voting is allowed. For companies incorporated in states that permit it, telephonic voting (also known as datagrams) for registered shareholders has been available for years. Since Delaware's 1989 liberalization of its laws, a number of companies have used datagrams. 70 For the first time, public companies and their transfer agents are permitting registered shareholders to vote on-line. For the 1997 proxy season, a transfer agent established an on-line pilot voting program that three public companies used. 71 Also in 1997, the first company permitted direct on-line voting by registered shareholders. 72
Almost all state laws require companies incorporated in their state to hold annual in-person shareholder meetings. 73 A few companies have provided shareholders electronic access to their annual shareholder meetings. In 1994, a company provided the first electronic access to an annual meeting through a supplemental satellite broadcast. 74 In May 1996, a company supplemented its traditional in-person annual meeting with the first "cybercast" of an annual meeting. 75 Internet attendance was open to the public. In 1997, several more companies supplemented their annual meeting on-line with cybercasts. 76
Beginning in late 1995, participants in several proxy contests have used the Internet to communicate their views. 77 Web sites used in proxy contests typically post proxy materials, press releases and letters. 78 To get publicity, the web site address typically is published in the print media. Half a dozen other shareholder disagreements have been aired on-line. On occasion, shareholders have opposed management initiatives on-line without soliciting proxies. Institutional investors are beginning to use secured web sites, which restrict access, to communicate with each other quickly during proxy contests. 79
Telephonic conference calls are widely used by public companies to alert financial analysts and institutional investors of their latest corporate developments. 80 In most cases, individual investors are not permitted to participate. 81 Although still rare, some analyst conference call transcripts and toll-free numbers for conference call replays are being posted on-line for the public's use. 82 Both of these services are limited to companies willing to have their calls available to the public. 83
To encourage the use of developing technologies, the Commission has taken a number of actions. The Commission's October 1995 interpretive release was an early source of guidance on satisfying delivery obligations of disclosure documents, and a big step towards eliminating perceived legal uncertainty that might restrain market participants from using electronic delivery. 84 Whether they use electronic or paper-based delivery systems, market participants carry the ultimate responsibility for choosing an appropriate method of satisfying their delivery obligations. The release provided the flexibility necessary to accommodate evolving new technologies and the differing circumstances of market participants.
The October 1995 and May 1996 interpretive releases also gave guidance to facilitate other new uses of technology. One interpretation clarified that a securities offering may be lawfully conducted entirely on-line. 85 Another clarified that a company may create multiple versions of the same document, provided that each meets applicable requirements. 86 The staff also has provided interpretive guidance or no-action relief that has facilitated novel and innovative applications of technology in other areas. These areas include electronic roadshows or using the Internet for private offerings.
Of course, many challenges remain. As technology continues to develop at a remarkable pace, the regulatory framework must evolve as well. 87 Some obstacles are related to technology itself, such as limited bandwidth creating slow connections to the Internet for many users. Other obstacles relate to technology users, including investors that differ greatly in their access to and ability to use new technology, and issuers that are unsure about how to use the technology.
Recent trends in the use of technology by public companies show the tensions that application of traditional securities law concepts confront when faced with what the Internet and other advances have made possible. Of course, they also show that electronic communications may be able solve current problems. Although the Commission and the staff have attempted to address some of these issues through releases and no-action letters, the Commission also has recognized that a broader review of the regulatory framework is necessary.
The historical regulatory approach to communication, particularly during offerings, may limit certain uses of electronic communications. During offerings, the Securities Act's approach is to restrict written communication that offers a security for sale, other than through the regulated prospectus. Violation of these restrictions can have serious consequences, including, potentially, the purchaser's right to require the company to rescind the purchase.
Companies, underwriters and legal practitioners are concerned that certain types of communications that occur on the Internet are inconsistent with the regulatory framework if they are viewed as forms of impermissible written communication during offerings. 88 The enhanced communication possibilities of the Internet are attractive. At the same time, though, freeing up communication during offerings -- whether on the Internet or elsewhere -- must be accomplished in a way that does not sacrifice investor protection.
The issues raised by the current regulatory framework for offerings in the context of electronic communications are many, including:
The Report of the Task Force on Disclosure Simplification, issued in March 1996, identified five "strains" in the regulatory system for securities offerings. The first one mentioned was technological developments in the field of electronic communications. The Report noted that "regulatory requirements that result in the imposition of artificial barriers to the flow of accurate information generally are not effective, in some cases not possible, and are viewed by some as not ultimately in the best interests of investors and the markets."
In July 1996, concurrent with the issuance of the Advisory Committee's Report, the Commission published a concept release on Securities Act registration and disclosure reform. 95 It sought comment from the public about broad reform of the capital formation regulatory framework. That concept release discussed "company registration," as recommended in the Committee's report, and other possible approaches to reform of the regulation of the offering process. The Commission received many comment letters in response to this release.
With this extensive study of possible ways to reform regulation of the offering process, the staff is now developing recommendations on how best to address the problems faced by industry participants and take advantage of widespread, fast communication made possible by technology, while continuing the strong tradition of investor protection.
b. Shareholder and Corporate Communications
Electronic media has the potential to greatly enhance communication by shareholders with each other, and communication by companies with shareholders. As described above, companies are beginning to provide information to shareholders electronically on web sites. The concerns that may be causing companies not to use electronic media for securities offerings do not appear to be deterring companies from choosing this avenue of communication for regular corporate communication outside the offering process.
With the Commission's adoption of broad proxy rule amendments in 1992, regulatory barriers to inter-shareholder communication were reduced. 96 As a result of these amendments, shareholders who are not soliciting proxy authority are now free to communicate -- in person, by phone or electronically -- with each other and company management on voting-related issues without worrying about the need to comply with proxy filing, disclosure and delivery obligations. 97 In addition, shareholders may, without incurring filing obligations, use the press and television broadcasts, as well as the Internet, to announce how they intend to vote on any proposal, and to explain the reasons for their voting decisions. 98
Five years later, some have suggested that these broad proxy reforms have "radically reduced the cost of shareholder communication." 99 As shareholders take greater advantage of the potential that electronic communication presents for reaching each other, the benefits of these reforms will become even more apparent.
Shareholders are concerned that voting-related communications, including those made electronically, that are no longer restricted by the proxy rules, nevertheless may subject them to the beneficial ownership reporting requirements of Section 13(d) of the Exchange Act. The concern is that these communications later might be found to have demonstrated the existence of a voting agreement among holders of more than five percent of a particular company's stock, or to have caused a "passive" institutional investor that itself owns more than five percent to lose the more favorable "short-form" Schedule 13G filing status. 100 The Commission has recognized this issue and has sought comment on how best to address it. Within the context of broader Section 13(d) rule proposals aimed at expanding the categories of 13G-eligible filers, the Commission has sought public comment on how best to balance the various concerns in this area.
New technology often offers exciting benefits to investors, issuers and other market participants. Beginning with EDGAR and continuing with Commission releases and other guidance, the Commission has studied, and will continue to study, the impact of technological advances upon its regulatory scheme with a view to allowing issuers to enjoy greater flexibility and investors to have access to better, more timely information.
Mutual funds 101 and other types of investment companies have recognized and capitalized upon the tremendous opportunities provided by technology. Funds sell their shares to a rapidly growing market, and are anxious to use new systems to locate and communicate with potential investors. As of the end of June 1997, U.S. investors had entrusted approximately $4.6 trillion to over 4,000 investment companies subject to Commission regulation. Over 38 million U.S. investors are shareholders in mutual funds. Because of the large amount of assets invested in investment companies, and because of the large number of investors who invest in investment companies for their retirement and for other purposes, the investment company industry plays a crucial role in the U.S. economy.
Many funds have successfully adapted electronic media into their operations and communications strategies. Technology has permitted more funds to reach out to more investors faster, and more cost-efficiently, than ever before. The Commission has responded to the promise of technology by flexibly interpreting the federal securities laws to accommodate new ideas, provided that they are consistent with investor protection. The success of this vision of regulation is evident when examining the uses of technology by investment companies.
The investment management industry uses electronic media:
Effective and on-going communication with shareholders has heightened importance for the mutual fund industry. Mutual funds have shown themselves to be attractive savings vehicles for investors of moderate means, often investing for college or retirement. The need to communicate with the millions of investment company shareholders, who frequently will purchase additional shares on an on-going basis (for instance, pursuant to investments in a retirement plan), drives much of the mutual fund industry's enormous investment in technology. Technology has made the explosive growth of the industry manageable.
While many funds have used electronic media to "reinvent" themselves to be more accessible to the average investor, many investors also have used electronic media to transform themselves into more sophisticated and well-educated consumers than ever before. Many third parties also have recognized the importance of investment companies in today's economy, and have developed information services that are tailored specifically for investment company investors. These third parties also have made extensive use of electronic media to reach investors, adding to the amount of information readily and inexpensively available.
The Commission has sought to facilitate innovation in the use of electronic media by the investment management industry, and will continue to be responsive to new ideas. Some of the recent growth in the industry may be attributable to the increasing use of electronic media by investment companies and investors. Not all investment companies and investors have embraced technology to the same extent, however. The market will ultimately prove the worth of technology -- whether the benefits to the industry and its investors of developing and using new services are greater than the associated costs. While many investment companies could realize significant cost savings by delivering all of their required disclosure documents electronically, many investors are not able or willing to receive them in this format. Thus, a system of pure electronic communication seems some distance away.
This chapter will discuss the regulatory framework relating to the use of electronic media by investment companies, the current trends in the use of electronic media by investment companies, and the Commission's regulatory approach to developments in electronic media as they relate to investment companies and their investors.
Like other issuers subject to the Securities Act of 1933, investment companies are subject to the disclosure requirements of the Securities Act and its philosophy that investors are best protected if they receive full and accurate disclosure of all material information about investment opportunities. Supplementing the disclosure requirements of the Securities Act are the substantive requirements of the Investment Company Act. These requirements are designed to address, among other things, conflicts of interest between a fund and its affiliates, and the day-to-day operations of investment companies, including pricing and redemption procedures.
For mutual fund disclosure to be effective, it must take into account the nature of the investor. More and more, individual investors are entrusting their life savings and retirement needs to mutual funds. 102 These investors need easily comprehensible information to guide them in making critical investment decisions. Mutual fund investors crave information, as shown by results of a survey of investors that indicated that 72% of the respondents were either somewhat or very interested in learning more about investing in mutual funds. 103 Information about investing in mutual funds is very plentiful in today's society, but investors need knowledge to evaluate their investment options.
Electronic media hold the promise of making communications between funds and their investors easier and more efficient. The Commission's recent disclosure initiatives should build on that promise by making the information that is delivered to investors more helpful and useful. The two electronic delivery releases issued by the Commission provide important guidance to the fund industry regarding the application of the federal securities laws to specific issues relating to the industry. As discussed in more detail later in this chapter, many fund groups have sought to follow the guidance in the releases.
Under the Investment Company Act, if funds do not offer their securities publicly, and limit their offerings to only certain types or a small number of persons, they will not be subject to Commission regulation as investment companies. Many of the funds relying on these exemptions refer to themselves as "hedge funds," a term not defined in the federal securities laws.
The Investment Company Act's exemptions provide various rules for private offerings, but today's vast communications networks leave few things truly "private." Because these funds and their managers typically rely on the private offering exemptions of the federal securities laws, their use of the Internet, which is accessible to anyone with a computer and a modem, has been problematic.
The Commission staff has attempted to resolve this tension, and has accommodated the desire of some private funds to use electronic media to distribute information about themselves to more potential investors. One company that proposed to establish a web site directory of information about private funds asked the Commission staff for guidance whether hedge funds (or their advisers) could provide performance data and other information to the directory, consistent with the private nature of their exemption, if access to the web site were limited to certain types of investors. The staff agreed that hedge funds could place information about themselves on the web site, thus allowing these funds to utilize Internet technology. 104
Like other issuers, investment companies are required by the federal securities laws to provide their shareholders with certain information on an on-going basis. 105 The tremendous growth in mutual fund investors, however, makes this task more difficult. The provision of this information to investors by means of electronic media can ease the task.
The investment management industry and fund shareholders have quickly embraced and developed many uses for new technology. In 1996, an estimated 30 million households owned a personal computer (or about 25% of all households in the country). 106 A 1995 survey showed that ownership of personal computers among mutual fund shareholders exceeded the national average. 107 The growing use of personal computers and the Internet by the public has not been lost on the financial services community. 108 A recent list of investment management firm web sites includes over 200 entries. 109
Traditionally, technologies have enabled investment companies to offer new services to investors, enhance their internal operations and realize cost savings. Today, technologies affect investors as well as investment companies. Only in the past few years have investors turned to their computers to receive information about their current and potential investments, and to conduct securities transactions. This change has significant consequences. The wealth of information available to investors using new technologies may allow them to enhance their understanding of the securities markets, and provide them with useful information about specific investments. Investors also have financial information available to them at less cost and with less effort than before. These benefits are consistent with the Commission's goals of not only protecting investors, but also teaching investors to protect themselves. 110
Twenty years ago, many individual investors did not actively manage their investments, either because they used brokers who provided this service, or because they placed money in savings accounts at banks or had defined benefit plans with their employers. 111 An individual investor in today's society, however, is far more likely to consider actively his or her financial circumstances and possible investment options. 112 The vast amount of information accessible to retail investors, and the various tools available to enable such investors to sort, search and save data quickly, have dramatically altered the profile of the "typical" mutual fund investor. Until recently, the only information that most investors received about mutual funds consisted of the fund's prospectus, and the advice given to them by brokers or other financial advisers. Today, an investor with a computer and a modem may instantly receive not only many funds' prospectuses, but also performance data, commentary about funds and reams of investment advice. 113 Technology has encouraged many individuals to research and track their portfolios using only a home computer.
As a result of this revolution in information availability, many investors believe they no longer need the assistance of a broker or other professional to do their financial planning for them. The Commission has recognized that millions of mutual fund investors are taking a more active approach to their investments, and has reexamined the information that it requires funds to provide to investors. Because many investors have complained that prospectuses and other required disclosure generally have not been very useful in making decisions to invest in mutual funds, the Commission has proposed amendments to its mutual fund disclosure program that are designed to provide investors with more useable information, whether provided through electronic media or on paper. As the Commission and the securities industry continue to accommodate the needs of this new retail investor, the power of electronic media likely will grow.
Changes in retirement investing have significantly affected the habits of individual investors. In the past, employers who offered retirement benefits most often provided defined benefit plans to their employees. Today, defined contribution plans are far more typical. An estimated 42% of the corporate work force is covered by a defined contribution plan, while only 24% is covered by a defined benefit plan. 114 By 2001, it is estimated that the amount of assets in defined contribution plans will increase to 53.7% of the total $4.1 trillion in private-trusteed pension plans, with 401(k) plans accounting for 37% of this percentage. 115
Defined contribution plans shift the investment risk associated with the investment of assets in a pension plan from the employer to the employee. In a defined contribution plan, although the employer makes contributions to the employee's account, the actual amount of retirement benefits that the employee ultimately receives will depend on how those assets are invested by the employee. This shift in investment decision-making responsibility has resulted in many employees taking a greater interest in the investment of their retirement assets. Many retirement plans offer employees a choice of investing in a variety of investment companies. 116 The percentage of 401(k) assets invested in mutual funds has increased from 9% in 1986 to an estimated 38% as of year-end 1996. 117
Many mutual funds sell their shares directly to investors without the use of an unaffiliated broker-dealer. These direct-marketed mutual funds were among the first types of fund companies to use the Internet, as it provided them with another channel of distribution for their shares. 118 Competitive pressures may have driven many funds to consider using the Internet to promote the sale of their shares. Because of the many sources of information available about investment companies today, and the large number of competitors in the industry, funds must find the most effective method to reach potential investors. Funds also seek to retain existing shareholders and often compete by providing enhanced services. As a result, many funds have decided to establish a web site dedicated to a particular fund group, post information on a web site of a third party with information about multiple funds, or use a combination of sites.
Investment companies are making their prospectuses available on-line to a much greater extent than other corporate issuers. Results of a recent survey of fund groups indicate that 76% of the respondents' web sites included prospectuses, and 32% permitted investors to download their prospectuses. 119 In contrast to other public companies, investment companies are using their web sites both to inform the public and to satisfy delivery requirements of the federal securities laws for shareholders that have chosen to receive documents electronically. Because investors may be able to obtain a fund's prospectus through its web site, thus receiving this document instantaneously, a well-written prospectus may serve as a helpful source of information for investors. As more investment companies place their offering materials on their web sites, comparisons of investment companies also could be simplified. Through its two releases, the Commission has provided significant guidance that has facilitated the ability of funds to provide prospectuses and other offering materials on their web sites.
Investment companies are making extensive use of the Internet. The results of a survey of fund groups indicate that 51% currently have a web site. 120 As for those surveyed fund groups that do not have a web site, 41% intend to establish a site by year-end 1997, and 21% intend to establish a site by year-end 1998. 121
The types of information made available on web sites by different fund groups vary due to the wide use of electronic media by the fund industry. Much of the information currently available on fund groups' web sites is specific information about the funds, advertisements and sales literature, 122 and more general educational information that also is available in print. (On-line information that is specific to individual shareholders is described in a later section of this chapter.)
A sophisticated web site can be expensive to create and maintain. 123 As discussed below, mutual fund sales on the Internet are still in the early stages of development, and it may be some time before it is clear whether web sites result in an increase to funds' bottom lines. In order for a web site to be profitable, it must either prove itself to be a viable sales channel, or it must reduce sales and advertising expenses. Web site technology holds tremendous promise compared with the cost of a service center or the costs of printing, mandatory toll-free telephone numbers, staffing telephones, processing and mailing. 124 There is virtually no incremental cost to deliver a fund prospectus to a prospective shareholder by the Internet.
Investment companies are not the only parties with fund-related web sites. Much information about investment companies is also available on other parties' web sites, including discount brokerages and providers of on-line directories of funds, discussed in more detail below.
i. Information About a Particular Fund. A prospective investor who browses a fund's web site may have ready access to large quantities of information about the fund. Examples of the types of information available on a fund's web site include: the category and investment strategy of the fund; the amount and classification of the fund's assets; the top holdings of the fund; the minimum investment required; performance information; risk information (such as a risk profile or volatility measures); information about portfolio managers; detailed information about a fund's fees; sales loads and expenses; distribution information and in some cases, information published by third parties, such as Lipper Analytical Services, Inc. or Morningstar, Inc. Many fund groups list their funds by category, so that an investor interested in, for example, bond funds, may see all of the bond funds offered by the fund group. Funds also are utilizing technology to permit shareholders to view more detailed information about the funds, such as recent portfolio purchase and sale transactions by the funds. 125
The extensive use of the Internet and related technologies by funds and investors may not only facilitate better informed investing; it also may lead to lower overall costs. Because an investor can compare the fees and other features of one fund to another on-line, some speculate that extensive use of the Internet and related technologies by funds and investors will result in increased competition among funds, which may place downward pressure on mutual fund fees and fees for other financial services. 126
ii. General Information. A fund group's web site may include a vast array of information tailored to many types of investors, including general information about the fund group, a glossary of investment terms, or sophisticated risk-management information. Fund web sites also may have information directed to retirement plan participants and administrators, in recognition of the large amount of retirement assets invested in funds.
Some funds try to differentiate themselves from their competitors by offering a variety of services on their web sites. A web site may have an interactive questionnaire that provides an individual with personalized information, such as a recommended asset allocation of the individual's assets among a variety of funds within the fund group's family of funds. Some fund groups offer a variety of "worksheets" or "calculators" to assist investors in choosing types of investments or determining asset allocation or savings strategies for retirement, college, or other purposes. Within seconds after answering several questions, an investor may receive a sample portfolio of types of mutual fund investments. Investors also can take quizzes to test their investing knowledge. 127
Many fund web sites have hyperlinks to the sites of third parties that provide fund-related information to investors. A number of funds also have hyperlinks to the EDGAR portion of the Commission's web site, thereby providing direct access to their own prospectuses, periodic reports and other documents filed with the Commission.
The Internet provides funds with another means to inform the public about the funds' products and services. Some funds forego establishing their own web sites and rely on the web sites of third parties. The web sites of third parties allow investors to receive large amounts of information about many funds in one location. Several on-line directories also list funds and have hyperlinks to fund web sites. Below are examples of some web sites of third parties that supply mutual fund information.
The NETworth web site provides information regarding thousands of mutual funds. 128 Within NETworth's "Mutual Fund Market Manager," an investor may obtain a report containing general information about a fund, as well as information about the fund's risk, performance, and management and a graph showing the fund's net asset value. A link to the fund's home page also may be available. A user identification and password are required in order to obtain certain information, including a description of a fund published by a third party. An investor also may use NETworth to obtain rankings of funds meeting the investor's particular investment objective and risk tolerance, as well as to search for funds that meet particular investment criteria. Fund commentary and book reviews also are available on the NETworth site.
An important service offered by NETworth assists funds in ensuring that their prospectus delivery obligations are fulfilled. A fund, like any other company offering its securities to the public, must provide a prospective investor with a copy of the fund's prospectus before the fund may lawfully accept an investment in the fund by the investor. A NETworth user who wishes to obtain a fund prospectus must enter the user's name and password, available free of charge by registering on-line with NETworth. This registration system allows NETworth, on behalf of the fund, to obtain from the user a consent to receive the prospectus electronically. At the same time, the investor is provided with the opportunity to request that fund prospectuses be sent on paper. NETworth also can report to each mutual fund the names of consenting investors who viewed the prospectus on-line. This report may be used to evidence delivery of the fund's prospectus, so that the fund can then permit the investor to download an application and invest in the fund. 129
Brill Editorial Services operates a web site entitled Mutual Funds Interactive that includes hyperlinks to many funds' web sites, as well as mutual fund news from Bloomberg L.P. and newsgroups. 130 The Mutual Fund Education Alliance's web site contains general educational information about investing in mutual funds, and links to numerous funds' web sites. 131 The Mutual Fund Cafe web site provides articles and information about the fund industry, including monthly reviews of industry trends and weekly analysis and commentary. 132
Certain discount brokers that serve retail investors have web sites that contain extensive information about funds. 133 For example, on the web site of a major discount broker, an investor may view lists of "select" and "top performing funds." To customize the information on this web site, an investor may enter different search parameters and perform a variety of searches, such as comparing "top performing" funds available through the broker, comparing funds matching the investor's criteria, or viewing the discount broker's analysis of a specific fund. A report about a particular fund may include information derived from the fund's prospectus, such as the fund's investment objective, expenses and fees, as well as other information developed by third parties, such as statistical measures of the fund's volatility ( e.g., beta and standard deviation). A brokerage web site also may provide a hyperlink to the broker's Internet trading area.
An innovation by the brokerage industry has been the establishment of "fund supermarkets." The OneSource supermarket was the first fund supermarket, organized by Charles Schwab & Co. in 1992. This supermarket currently has approximately $110 billion in assets. 134 One reason given for the growth of supermarkets has been the decrease in fees as a result of electronic trading. 135 Through a fund supermarket, an investor may purchase shares of funds from hundreds of different fund groups.
Funds may provide information about themselves through commercial on-line services, such as America Online ("AOL") or Microsoft Network, among others. For example, AOL's Mutual Fund Center has educational and general information about funds. Live chat sessions also are available on the site. Investors having an account with these services may be able to purchase and redeem shares on-line, if they have accounts with participating brokerages.
Investment companies have aggressively used new technologies to communicate with their shareholders, as well as to deliver prospectuses and other required information to shareholders. Investment companies also have used new technologies to provide their shareholders with the opportunity to communicate with them electronically. This correspondence may take the form of general questions, or applications to invest. A fund also may permit an investor to send an on-line consent to receive information electronically, rather than sending the consent through the mail.
According to a survey of fund groups, 76% of the respondents' web sites have e-mail availability, and 20% permit the local printing (at the investor's printer) of investor service forms, such as change of address forms. 136 An official at a large mutual fund group recently reported that close to 15% of the group's interaction with investors is through the Internet, and predicted that the percentage would grow to about 60% in ten years. 137
While a large number of fund groups provide prospectuses and general information on their web sites, fewer fund groups currently offer personalized information, such as account statements, and the ability to conduct on-line transactions. 138 Results of a survey of fund groups show that only 24% of the respondents' web sites allow shareholders to view their current account and account history. 139 This small percentage may be due to security concerns. 140 A growing number of fund groups, however, are providing personal account information through their web sites. 141
Many funds are using their web sites to provide their shareholders with information that is required under the federal securities laws. As discussed previously in this chapter, numerous fund groups are providing prospectuses on their web sites. Certain fund groups also are making semi-annual and annual reports available on their web sites. According to a survey of fund groups, 13% of the respondents allow semi-annual and annual reports to be downloaded. 142 Providing reports in this manner reduces printing and mailing costs, and may allow investors the ability to search more efficiently within a document, and to hyperlink to other reports or third party publications. A fund group also may place additional information on its site, such as information about the funds' recent portfolio purchase and sale transactions.
While many parties use electronic media to distribute general and specific information to investors, new technologies have the potential to allow more complicated functions, such as on-line transactions. Several fund groups have begun to offer investors the ability to purchase and exchange 143 shares on-line. 144 One discount broker reported that almost 10% of its customers' mutual fund trades are completed through the Internet, 145 and 6% of those fund groups responding to a survey permit the purchase of fund shares on their web sites. 146 Increased on-line trading may result in decreased costs to investors. 147 The costs of printing and mailing paper prospectuses and other literature can be several dollars per account. In contrast, the cost of delivering that information over the Internet is far lower.
In order to conduct mutual fund transactions on-line, an investor usually must establish an account with the investment company or with the investor's broker, depending on how the investor purchases the fund shares. The investor also must obtain a password or personal identification number, and own hardware that meets certain technical specifications.
An important concern of funds that offer or plan to offer on-line transactions is security. Funds have adopted a number of measures to protect against breaches in security of their web sites. 148 Security issues nevertheless dominate conferences and publications directed to mutual fund managers, as funds work to ensure that their systems are secure and capable of handling on-line transactions. 149
Security also is a concern for mutual funds that redeem investors' shares on-line. Under the Investment Company Act, mutual funds must redeem shares based on the current net asset value of the shares that is next computed after receiving a redemption request. 150 If a breach in security interrupts the payment of the redemption proceeds by the fund, the fund could be unable to meet this obligation.
Electronic media are beginning to affect the administration of retirement plans. Many employer/sponsors of defined contribution plans have sought to comply with rules under the federal pension laws 151 by providing their employees with information about the funds offered through the plans over the employers' intranets, or by working with the offered funds to make available to employees information already located on the funds' web sites. Fund web sites with retirement plan information may offer interactive savings worksheets, market and fund performance information and answers to questions on retirement planning. 152 Certain fund web sites also have information available to administrators of 401(k) plans.
There are many uses for new technologies in the administration of defined contribution plans. Plan sponsors are searching for uncomplicated ways for their employees to receive account balances, and interactive technology may facilitate this process. Some providers are creating terminals with retirement plan information that are similar to ATM machines. 153
While advanced technology offers many opportunities, it comes with a price. A survey indicates that, although 44% of 401(k) plan participants would consider switching 401(k) plan providers if offered advanced technology, the same percentage would not switch providers. 154 Only 10% of those surveyed indicated that they would pay 10% more for advanced technology. 155
Many new products and services in the investment company industry would not be feasible without advances in computer technologies. Investment companies use computer programs and applications in the allocation of their assets, in their accounting and to meet their pricing requirements under the Investment Company Act. 156 As the number and sophistication of investors in investment companies have increased, investors' desires for different types of funds and pricing structures have increased as well. Investment companies are increasingly using computer technologies to develop new products and services to satisfy those demands.
Quantitative, or "quant," funds use computer models to screen stocks based on predetermined criteria such as earnings momentum, price/earnings ratios, and relative price. With these funds, the computer generates most, and in some instances all, of the investment decisions. While these funds have not yet achieved widespread popularity, some believe that the introduction of quant funds by Fidelity Investments and Schwab signals future growth. 157 One fund's model consists of a three-step process that evaluates 1,300 stocks based on 40 different valuation factors, Wall Street analyst recommendations and insider selling patterns. Following this evaluation, the computer optimizes the fund's portfolio to obtain risk/reward potential and to produce industry diversification similar to that of the S&P 500. The final portfolio consists of 50 to 100 stocks. 158
Competition for investment assets has been intense, and has led to innovations in the structures used to aggregate assets under management in collective investment pools. Technology has enabled funds to develop and manage those new structures in a cost-efficient manner. One recently developed structure in the investment management industry is the master-feeder (or hub-and-spoke) arrangement.
In a master-feeder arrangement, one or more feeder funds (or spokes), each of which is tailored for and sold to a particular category of investors, invests its assets in a single master fund (or hub). Investment management takes place at the master fund level, while distribution and other services occur at the feeder level. A master-feeder structure allows a fund group to sell feeder funds through several distribution channels to different categories of investors, to spread fixed expenses among a greater amount of assets and provides the possibility of greater diversification due to the larger asset base.
The holdings and cash flows of feeder funds must be reconciled daily with those of the master fund, and computer technology facilitates these tasks. Fund accounting software and other data processing systems have been specifically designed for these types of funds. 159
Technology has enabled foreign money managers to offer U.S. investors the opportunity to purchase shares in funds that are substantially similar to those sold outside the U.S., but that are registered under, and have the protection of, the federal securities laws. These funds are commonly referred to as "mirror funds." 160 Due to legal limits (discussed below) placed on the ability of any non-U.S. fund (a fund formed under a jurisdiction other than the United States) to sell its shares publicly in the United States, the manager of a non-U.S. fund may seek to register in the United States as an investment adviser and establish a mirror fund registered in the United States that invests in the same securities as a fund in the adviser's home country. This U.S. "mirror fund" may then be offered to investors in this country. Computer software has been developed that is designed to facilitate the management and operation of different mirror portfolios by a single investment adviser. 161
Technology has allowed mutual funds to provide enhanced services to fund investors that would not have been feasible before the advent of advanced computer systems. Most funds calculate their net asset values once daily, 162 and all purchases and redemptions each day are effected at those net asset values. Advanced computer and communications technologies have enabled at least one fund group to offer a series of funds that are priced and stand ready to sell or redeem their shares on an hourly (rather than daily) basis during regular business hours.
The Commission has taken a number of actions to facilitate the use of electronic media by mutual funds and other members of the securities industry. Most important for mutual funds are the two interpretive releases that the Commission has issued on the use of electronic media to satisfy disclosure and delivery obligations under the federal securities laws. These two releases demonstrate how the Commission has used the flexibility inherent in the federal securities laws to facilitate the use of new technology, while at the same time ensuring the continued protection of investors.
The October 1995 Release, which was the Commission's first significant step toward eliminating the legal uncertainty that had previously surrounded the use of new technologies to satisfy delivery and disclosure obligations, provided important guidance for market participants that wished to use these technologies. As described in the previous chapter, the release established that issuers and others are free to choose to effect delivery electronically, provided that investors have notice of the availability of electronic disclosure, that investors receiving electronic disclosure documents be able to access them, and that those providing disclosure electronically obtain evidence showing that the recipient received the information.
In May 1996, the Commission issued a second release that extended the framework of the October 1995 Release to broker-dealers, transfer agents and investment advisers. The May 1996 Release discusses issues unique to the electronic provision of customer-specific information, such as confirmations and account statements, to individual investors. Although the May 1996 Release permits regulated entities to use new technologies to transmit such information, it reminds those who use new technologies of the need to take steps to ensure the integrity, confidentiality and security of customer-specific information just as they would in paper-based systems. The Release also states that regulated entities should obtain their customers' consent before providing personal financial information to them electronically.
In other areas, the Commission staff has provided interpretive advice to market participants that have developed innovative uses of technology. While the drafters of the federal securities laws never contemplated the type of innovation allowed by today's new technologies, the Commission and its staff have been able to facilitate technological innovation without sacrificing investor protection.
The Internet and related technologies are being used extensively by fund groups, other financial service providers and publishers to provide investors with a significant amount of information about investment companies. Much of this information is useful and serves to inform investors. The Commission has recognized that the disclosure it requires of investment companies also must be concise and clearly written in order for investors to benefit fully from the greater access to information offered by electronic media. 163 The Commission's disclosure initiatives have been designed to provide investors with this type of information, so that they may they find it easier to use a fund's prospectus and other offering documents to learn about the fund or to make their investment decisions. 164
Many investors have told the Commission that they prefer to compare funds by referring to a document that describes, in a standardized format, the key features of a fund. Partly in response to investors' preferences, the Commission has proposed a "fund profile" initiative. This initiative offers a new disclosure option that previously was not available to funds or their investors. The proposal would permit a fund to provide investors with a document that would summarize key information, including a risk/return summary, 165 and other information about a fund's investment strategies, goals and fees, in a concise, standardized format. 166 The profile also would include basic information about the fund's investment adviser and portfolio manager, purchase and redemption procedures, tax implications and shareholder services. 167
Both the fund profile proposal and the proposal to amend the fund prospectus recognize the widespread use of mutual funds in defined contribution retirement plans. The proposals give funds the flexibility to tailor prospectuses and profiles intended for use in this market by permitting them to omit information, such as purchase and sale procedures, that is not relevant to plan participants. This flexibility may particularly serve parties that have web sites specifically for (or portions of their sites devoted to) investors in employee benefit plans.
While technology has created opportunities and benefits for investment companies, their investors, and regulators, it also has created challenges. As technology continues to develop at a rapid pace, the regulatory framework of the federal securities laws must evolve as well. The Commission faces challenges to facilitate and respond to developments in technology. 168 Some challenges are related to technology itself, such as the need for secure means of communicating private information or transmitting monies on-line, and ensuring the ability of an investor to redeem shares in a fund. Others arise from the nature of the Internet itself -- which provides unique opportunities for international communication. It will be a challenge to ensure that this generation of investors, with access to more information than their parents had in a lifetime, has disclosure documents that are helpful and that will guide them in making informed investment decisions.
The fund industry must continue to seek out those security devices that protect the integrity of on-line transactions against the risk of theft of investors' payments and proceeds. Mutual funds also must ensure that their systems allow them to redeem an investor's shares within seven days upon the investor's request. 169 The vast numbers of individuals and institutional investors buying, selling and exchanging fund shares make attention to security concerns imperative. Judging only by the number of articles, conferences and consultants devoted to the issue of the security of electronic transmissions, it appears that the industry recognizes this as one of the most significant operational business considerations facing the fund industry at this time. The Commission staff has engaged in discussions with industry representatives regarding security issues, and is monitoring funds' development of systems designed to ensure the integrity of electronic transactions.
Fund supermarkets have created a new and popular forum for mutual fund investors. Some commentators attribute the primary forces behind the growth of this new distribution channel to the millions of computer-savvy investors going on-line to use the resources of these rapidly expanding networks. 170 As indicated earlier, fund supermarkets offer investors many advantages over investing directly with individual fund groups. They offer a larger selection of funds, consolidated account and tax statements, the ability to switch among funds without incurring transaction fees, distributions "swept" into a single money management account, on-line and software tools for planning, research and analysis, convenient trading on the Internet at a discount and financial planning advice. 171
As supermarkets have developed, the Commission staff has needed to provide interpretive guidance to one supermarket sponsor regarding the rules governing the timing of purchase or redemption requests. 172 This guidance should allow investors that use supermarkets to make purchase and redemption requests on an equal basis with those investors that engage in the same transactions directly with a fund.
c. International Offering Issues
The international nature of the Internet poses particular challenges under the Investment Company Act. 173 Under the statute, few funds organized outside the United States are able as a practical matter to register their securities with the Commission.174 Because of the Internet's ability to reach investors worldwide, mutual funds that make information about their securities available on the Internet may inadvertently become subject to U.S. law or the laws of multiple jurisdictions.
The Commission is undertaking several international initiatives in response to the specific challenges raised by the cross-border distribution of funds and investment management services through the Internet. Staff members have engaged in discussions with the industry in response to concerns regarding the appropriate jurisdictional reach of regulators over investment company web sites. The Commission also has played a key role in the International Organization of Securities Commissions ("IOSCO"), an organization composed of securities regulators around the world. IOSCO has surveyed its members on how the Internet is used for the cross-border distribution of mutual funds and investment management services, and how other members regulate mutual funds and investment management services provided through the Internet in each IOSCO member's jurisdiction. IOSCO also has created an Internet Task Force discussed in Chapter V to study these and other issues raised by the Internet and to coordinate IOSCO's recommendations.
To minimize any regulatory uncertainty that the uniquely global nature of the Internet may raise, the various Divisions within the Commission are working with the industry and within IOSCO. Any possible changes to maximize the benefits of new technology must take into account the primary mandate of the securities laws, the protection of investors.
While the full effect of recent technological developments remains to be seen, these developments have significantly changed the ways in which many investors obtain information about their investments and conduct financial transactions. These technologies have many advantages for investors. The Commission has worked actively to facilitate the use of new technologies by mutual funds so that they may communicate with investors more effectively and provide shareholders with innovative services, without sacrificing investor protection.
Information is central to the investment advisory industry. New computer and electronic communication systems have made an enormous amount of financial information more readily available both to investment advisers and investors. This chapter will address the use of new technologies by investment advisers, the regulation of that use, and the Commission's approach to the issues arising from the use of new technologies that affect investment advisers and their clients.
New technologies already allow advisers to gather, assimilate, and analyze information faster and less expensively than ever before. This same wealth of information, and the ease with which it may be obtained, also has allowed many individual investors to learn more about their investments, and about the types of questions that they should ask when dealing with investment advisers.
An investor using today's computer technology may inexpensively obtain information that just a few years ago was available only from limited sources. Some argue that today's technology levels the playing field between individual investors and more sophisticated professional investors. 175 Many members of the securities industry now offer asset allocation software and similar features on their web sites. Many books and articles also have been published about web sites that provide assistance with asset allocation. 176 Various entities also provide individual investors with extensive lists of mutual funds from a variety of different fund groups. All of these technological advances may cause investment advisers to rethink and reshape the way in which they conduct their businesses to keep and to attract computer-savvy investors.
The access to a large amount of information about investment opportunities has not necessarily caused investors to forego using the services of investment advisers. Instead, individual investors, like professional investors, can identify categories of information they need to obtain from their advisers in advance, and can prepare questions about particular investments for their advisers based on their computer research. Other investors may be more likely to seek professional investment advice because, as a result of new technologies, they may have difficulty determining which particular investments to choose or sources of information on which to rely. 177
Mutual fund distributors anticipate that investment advisers will continue to play an important role in the marketing of mutual funds. As a consequence, distributors are using new technologies to provide enhanced services to advisers. Investment advisers also have begun to request that more information be provided on-line by those parties to whom they direct their clients' business. Some of the same fund distributors that are providing enhanced services to investment advisers also are providing investors with complimentary asset allocation information on-line.
Investment advisers recognize that the new technologies are valuable research tools. The business of providing sound investment advice frequently hinges on the availability of and access to large amounts of information. Advisers must choose those investments that are suitable for their clients. Investment research and the ability to distill and analyze vast amounts of information are important elements of a typical adviser's investment decision-making process. The large amount of information that is currently available through new technologies permits advisers to learn about opportunities that they would not otherwise know about, which may help them to better serve their clients.
As described in the previous chapter, investment companies are using new technologies primarily to provide information and services to current and potential shareholders. Investment advisers are using new technologies not only to provide services, but also to obtain information and to more efficiently serve their clients. Because investment advisers' use of new technologies is quite varied, the future effects of technology on the investment advisory industry are not entirely clear.
Investment advisers are using new technologies:
The Investment Advisers Act of 1940 generally defines an investment adviser as any person who receives compensation in connection with its business of advising others about investing in, purchasing, and selling securities. 178 Unlike the Investment Company Act, which has detailed, substantive requirements, the Investment Advisers Act primarily addresses the activities of investment advisers through more general rules that center on an adviser's status as a fiduciary with respect to its clients' assets. The Investment Advisers Act does not distinguish between investment advisers that provide investment advice electronically or those that provide investment advice in a more traditional manner.
Investment advisers typically have provided their services to two groups of clients. An adviser may contract with an individual to provide money management services based on the client's specific needs. Alternatively, the adviser may provide its services to a group of persons through a pooled investment vehicle, such as a mutual fund or a limited partnership. Investment advisers, however, are not the only parties from whom investors receive information or advice about their investments. For example, investors also obtain investment advice from publications. Under the Investment Advisers Act, a publisher is excluded from the definition of "investment adviser" if the publication is bona fide, is of general and regular circulation and does not offer individualized advice tailored to the investment needs of specific clients. 179
Under legislative changes implemented in 1996, certain investment advisers are required to be registered with the Commission, and others must register with state securities regulators. 180 Those advisers that have a small number of clients and do not hold themselves out to the public as investment advisers are not required to register as investment advisers with the Commission. 181
The Commission has established a page on its web site with a list of frequently asked questions and answers ("FAQ") regarding the regulation of investment advisers. 182 The FAQ provides hyperlinks to other sources on investment adviser regulation (including those that are on the Commission's web site), such as Commission releases under the Investment Advisers Act, general information on investment adviser regulation, an explanation of how to register as an investment adviser, the web sites of several state securities commissions, and the North American Securities Administrators Association, Inc.'s web site. 183 The information in the FAQ may assist current advisers, those that wish to become advisers, and investors who would like to learn more about the investment advisory industry.
The number of investment advisers has grown dramatically in recent years. Prior to the recent amendments to the Investment Advisers Act, most advisers were required to register both with the Commission and with the states. Congress recently amended the Investment Advisers Act to reallocate the responsibility for the regulation of investment advisers between the federal and state governments. In general, an investment adviser that (1) has less than $25 million in assets under management and (2) does not advise a registered investment company, is now regulated by the state in which the adviser maintains its principal office and place of business. Such an adviser generally is prohibited from registering with the Commission. Advisers that are prohibited from registering with the Commission, however, may seek an exemption from the prohibition if the prohibition would be unfair, a burden on interstate commerce, or inconsistent with the purposes of Section 203A of the Investment Advisers Act, 15 U.S.C. 80b-3A. 184
The recent amendments to the Investment Advisers Act have a significant effect on certain persons who provide investment advisory services electronically. Many individuals now look to their personal computers to receive information about their investments. In the past, the parties that created and disseminated computerized asset allocation and other similar programs were required to register with both the Commission and state securities regulators if they met the definition of "investment adviser." Today, as a result of the recent amendments, if those parties do not have at least $25 million under management, and they often do not, they are regulated as investment advisers only by the states in which they engage in business.
Earlier this year, the Commission adopted various rules that implemented certain provisions of the recent amendments to the Investment Advisers Act. In the rule defining the term "place of business," the Commission recognized the changing investment advisory industry and the special needs of advisers that provide advice through the Internet. In the release accompanying the rule, the Commission provided an example of the application of the rule to an adviser that offers advisory services through an Internet web site. 185 The example demonstrates that, although Internet communications may be accessible anywhere, an adviser must either have an office in a state, or hold itself out as conducting its business in a state, before it will be deemed to have a "place of business" in, and thus be subject to regulation by, a particular state.
Historically, the information available to investors about investment opportunities was frequently difficult to locate and use, and expensive to obtain. Many investors sought the advice of professionals, including investment advisers, broker-dealers and publications, for advice concerning investing.
New technologies have provided many investors with a multitude of information about their investments, often at no charge. In recent years, many investors have begun to search the Internet for information about their investment options. For example, an investor may search the World Wide Web and, within seconds, find 3,372 web sites with the term "investment," and 3,567 web sites with the term "security." 186
As investment companies and other issuers use new technologies and provide more information on their web sites, advisers are requesting that sections of these web sites include information exclusively for advisers. Advisers are obtaining other research electronically from a variety of sources. Some of these sources provide complimentary information that also is available to individual investors. Advisers also are using computer technologies to more efficiently administer their clients' accounts.
As investors become more comfortable with computers, and realize the vast array of financial information that is available on-line, more investment advisers have begun to provide advisory services on-line. Advisers also have begun to advertise their services using their own web sites or sites with information about a number of investment advisers. Developments in computer technologies also are enabling advisers to offer new types of advisory services to clients.
Future trends in technology may continue to change the relationship between investment advisers and their clients. As advisers and investors learn more about the potential of new technologies, the types of services provided by advisers and the services requested by their clients likely will continue to develop.
A wide variety of computerized programs and web sites currently provide users with information about securities. Some of these programs and web sites are sponsored by members of the securities industry and may be used in a variety of ways, such as to promote funds in a particular fund group, or investments that are sold by a particular broker-dealer. Programs frequently offer sorting capabilities that enable an investor to define particular criteria, such as investments with certain historical returns or fee structures, and provide a list of investments that satisfy those criteria. 187 In other programs, an investor is asked several questions concerning his or her financial history, background, and goals, similar to questions frequently asked in a face-to-face meeting with an adviser, and receives information showing either specific investments or suggested categories of investments. Programs may be associated with certain types of investing, such as retirement investing (described below) or investing for college. With many of these programs, the user does not enter into a contract with the sponsor of the program, and there are no communications between the user and the sponsor other than the operation of the program.
Certain investment advisers are offering investment advice on-line and recommending specific investments for a fee. As an example, one investment adviser's web site offers to provide personalized investment plans, buy/sell recommendations, and other services in exchange for a yearly subscription fee. 188 Other investment advisers have established sites that furnish investors with on-line advice about investing in mutual funds. 189 Advisers providing on-line advice, as well as advisers that use other media to provide their services, must fulfill their obligations to provide suitable advice to their clients. 190 Advisers providing on-line advice therefore must ensure that any questionnaires completed by their on-line clients will provide sufficient information to enable them to fulfill this obligation.
Certain advisers are providing on-line investment advice that is specifically directed to defined contribution retirement plan participants. 191 For example, one adviser has developed software that uses data from its client companies to create an investment plan for each participant based on a participant's investment knowledge, experience and investment objectives. This information is provided to the participant over the Internet. 192 Other investment advisers have web sites that contain information specifically about retirement planning and investing. Some fund groups and broker-dealers have "calculators" on their web sites that allow investors to input data relating to their projected year of retirement, their age, anticipated income level, and rate of return assumptions. The program supplies the investor with a proposed retirement strategy, including the amount needed to be saved on a monthly basis, and suggested investments.
The Internet is not the only electronic medium that advisers are using to serve their clients. A recent development in electronic investment advisory services is a plan recently announced by one bank. The bank will offer two-way video conference rooms in its branches that will be connected to investment advisers at a service center in a remote location. 193
Over the past 20 years, investment advisers have been using wrap fee programs as a means of providing investment advice. In a wrap fee program, a client typically is provided with asset allocation, portfolio management, transaction execution and related administrative services for a single fee based on the size of the account. In a mutual fund wrap program, clients' assets are allocated only among specified mutual funds. Wrap fee programs are designed to enable an adviser to provide individualized advisory services to a relatively large number of clients. These programs permit more clients with relatively small amounts to invest to hire advisers that otherwise would accept only clients with large amounts of money to invest.
Assets in wrap fee programs have grown tremendously in recent years. Some predict that wrap fee programs will continue to experience significant growth due in part to technological advances that have reduced processing costs. 194 An important regulatory issue for a company considering offering a wrap fee program is whether the program falls within the definition of an investment company contained in the Investment Company Act and is subject to regulation under that Act. Recognizing the importance of this issue to the growing number of wrap fee sponsors, the Commission issued a rule providing guidance as to the attributes of a wrap fee program that would not be subject to the strictures of the Investment Company Act. 195
Several companies market software that is designed specifically for providers of wrap fee programs. 196 This software may include programs related to sales presentations, performance reports, allocation methods and other subjects. 197 Because this software is now available for use by anyone with a personal computer, it may allow smaller financial institutions, such as community banks and regional brokerdealers, to provide asset allocation services that previously were offered primarily by larger institutions. 198
Investment advisers that provide their services using both traditional and developing media are beginning to use new communications technologies to distribute information to and communicate with current and prospective clients. Advisers also are using electronic services provided by fund groups, brokerage firms and others to develop their client base.
According to a recent survey of money management firms, about 30% of the firms polled stated that they have established web sites. 199 Client communications appear to be one of the most important uses of the Internet by money managers. 200 A separate survey of registered investment advisers indicated that about 60% of the advisers use the Internet for communications, and almost 80% believe that they will do so in five years. 201
An adviser's web site may include information about the nature of its clients, the adviser's investment objectives and strategies, and how it monitors its investment portfolios. Other items that advisers may distribute electronically include advertisements for their services and brochures. In its May 1996 Release, the Commission provided guidance regarding the applicability of the federal securities laws to the electronic delivery by advisers of advertisements, brochures and other information.
Several on-line directories of and guides to investment advisers have been established. These directories vary from providing general information about particular advisers, 202 to providing analyses of investment advisers, including performance information, information about the types of accounts managed by the advisers, risk/return profiles and fees and expense information. 203
Advisers also are using services provided by sponsors of fund supermarkets 204 to develop their client bases, and sponsors of fund supermarkets are searching for additional ways to increase their appeal to advisers. Results of a survey of registered investment advisers indicate that 21% use fund supermarkets currently, and 63% said that they will begin using them within five years. 205 Certain fund distributors are developing programs that refer investors to advisers. The sponsor of one of the largest fund supermarkets, Charles Schwab & Co., began such a service in 1996. Its AdvisorSource service refers investment advisers to Schwab brokerage customers that have at least $100,000 in investable assets.
Certain investment advisers devote a substantial portion of their time to researching potential investments and other economic data from a variety of sources. Some of these advisers recognize the potential of new technologies to assist them in their research, and distributors of financial and economic information are using new technologies actively to provide investment advisers and other financial professionals with information in a convenient manner. Results of a survey of registered investment advisers indicate that, while only 12.8% of advisers currently use the Internet for research, 28% expect to do so within five years. 206
In researching an issuer, such as an operating company or a mutual fund, an investment adviser may review information filed by the issuer with the Commission or otherwise provided by the issuer about its own financial performance. Information filed with the Commission, such as periodic financial reports, is available on EDGAR. Public companies also may supply investor relations materials on their web sites.
Fund groups and other distributors of funds often have information on their web sites that is specifically directed to investment advisers. The sites may have general information for advisers about the fund group's services, as well as forms and applications. A fund group also may provide summaries of information about individual funds that advisers may copy and send to their clients. 207 To assist advisers in obtaining specific information about particular client's investments, a fund group may have a password-protected area on its web site with information about client account balances, transactions, and sales tools. 208 Funds also are beginning to provide automated trading systems to investment advisers. Other sources that advisers may use to receive information about funds are the web sites of third parties, such as Morningstar, Inc., Lipper Analytical Services, Inc. and other information services. 209
Many broker-dealers and other financial institutions publish investment reports on countries, markets, industries and individual companies. Investment advisory firms often use these reports to develop new investment ideas for their clients and to monitor client accounts. These reports often are available electronically.
An example of a service that provides these reports electronically is Morgan Stanley's "Client Link" service. This service allows investment advisers to access Morgan Stanley products and services using the Internet, including equity and fixedincome research, securities market information and offshore securities market information. The service allows research to be archived, and includes electronic search tools to facilitate the research of databases. To use Client Link, a party must be a client of Morgan Stanley and assigned a user name and password.
Advisers frequently receive financial information from newsletters. Certain web sites include the text of newsletters or information about newsletters. 210 Other web sites offer securities analysts' reports, analyses of economic statistics, and similar publications of interest to investment advisers.
Investment advisers and their clients benefit from real-time electronic delivery of brokerdealers' reports and similar information because it eliminates delays encountered in distributing those materials through the mail. Advisers and their clients may use the electronically provided information in a more timely fashion. Services that offer search, monitoring and retrieval features enable portfolio managers to focus on and keep track of the precise information that they need without reviewing irrelevant material.
Several foreign stock exchanges have established web sites that provide access to information that may be useful to investment advisers and their clients. These web sites may inform advisers and their clients about the investment opportunities in specific countries. Through hyperlinks on a foreign stock exchange's web site, an adviser or client may access the web sites of issuers and financial institutions, including research materials.
Information providers have created a variety of electronic information systems that are used by investment advisers. Many of these systems are accompanied by electronic searching sorting, and monitoring functions. Several news services offer automated alert functions that provide the user with an audible or visual notification if news or information becomes available about certain issuers or other topics selected by a subscriber. For example, one service sends its subscribers e-mail alerts whenever any of 15 specified companies or mutual funds makes a filing with the Commission. 211 These services may allow users to save information electronically for time periods designated by the user.
Investment software vendors offer services that calculate and process statistical measures. These services also may provide sorting capabilities that allow an investment adviser to create a sorted list of securities meeting each of the investment adviser's criteria.
Investment advisers also may take advantage of a wide variety of market, economic, and other statistical information gathered and collated by various U.S. government agencies. Access to many of these resources is available through the Internet at <http://www.fedstats.gov>. This site includes hyperlinks to more than 70 federal agencies.
Information management is especially important for investment advisers because of the large amount of financial information available from multiple sources. Many investment advisory firms now have investment research, management, and trading facilities located in multiple countries around the world. Many global investment management firms have developed intranets to support the communications necessary to their operations. An intranet may be used by advisory employees to share information, including securities research and trading data. For example, an investment adviser or compliance officer may review detailed holdings and pricing reports on the adviser's intranet system, and may access other records, such as proprietary trading reports or personal trading records, to determine whether certain policies or procedures have been satisfied.
Investment advisers or their affiliates frequently are responsible for providing administrative services related to their clients' investments. Advisers are choosing services that offer technological innovations to serve their clients' administrative needs. Examples of the types of automated administrative services available include: (1) portfolio accounting systems that automate recordkeeping and accounting functions; and (2) online, realtime pricing services.
Several companies have created computer software and on-line systems that provide accounting and recordkeeping services. These systems may include features such as audit information for transactions and accounting entries, and automated updates of a portfolio's general ledger. 212 Other programs may offer recordkeeping and retention capabilities designed to satisfy an investment adviser's regulatory obligations. 213 Advisers also may use these systems to retain, archive, and retrieve items, including registration statements, proxy statements, and shareholder reports.
Certain pricing services provide daily market prices for some or all of the portfolio securities of the investment advisers' clients. These services may allow investment advisers to fulfill the periodic pricing obligations more quickly and efficiently.
Pricing services may include automated computertocomputer interfaces between an adviser and a thirdparty pricing service to value global and domestic securities, or online access to current market quotations and thirdparty pricing services. Pricing data accessed through various services is available for securities traded on exchanges and over-the-counter, and for major indices (e.g., Dow Jones Industrials, S&P 500 and Nasdaq). 214 This data is available in either realtime or delayed format, depending on the service provider and level of service purchased. The trading staffs of investment advisers generally require realtime services, while the needs of other staff members may be satisfied with lesscostly delayed information. Certain information vendors provide automated pricing information to mutual fund custodial and accounting software programs in order to quickly and accurately determine daily (or hourly, under certain circumstances) mutual fund net asset values.
New technologies are enabling investment advisers to provide additional services to advisory clients in a more efficient manner. The Commission has facilitated the use of new information and communications technologies by advisers through its interpretive releases and by providing additional legal guidance to advisers. The Commission has recognized the many benefits that technology may provide for advisers, and has sought to interpret its rules flexibly in order to facilitate those innovations that are consistent with investor protection.
Many legal issues have arisen regarding technology and investment advisers, including whether certain activities would cause a person to meet the definition of "investment adviser." Other legal issues relate to the use of Internet technology by unregistered investment advisers, the use of electronic media to communicate with clients, the distribution of adviser advertisements over electronic media, and enhanced recordkeeping.
Even before the widespread popularity of electronic media among investors and financial services providers, the Commission frequently faced questions concerning whether a party that provides information about securities by issuing an analysis or report is an investment adviser. 215 Today, with the widespread use of electronic media, the questions are more compelling. In evaluating the status under the Investment Advisers Act of entities that provide investment information using electronic media, the Commission staff has often drawn on analogous examples in the paper context, such as directories that provide lists of entrepreneurs to targeted investors, or texts that provide information about securities. 216 Moreover, many parties that provide information about securities electronically do not manage assets, and because of the Coordination Act, would not be permitted to register as investment advisers with the Commission.
Certain services, including computer bulletin boards, may be used to introduce entrepreneurs to potential investors. For example, with the assistance of the Small Business Administration, several universities and non-profit entities ("Network Operators") proposed to operate an electronic listing service ("Network") to list small corporate offerings without the Network and the Network Operators registering as investment advisers under the Investment Advisers Act. The Network's home page allows accredited investors to obtain a password-controlled listing of small corporate stock offerings that are exempt from registration under the Securities Act and download offering circulars. No transactions or negotiations occur through the Network. The staff agreed that the Network and the Network Operators could engage in the proposed activities without registering under the Investment Advisers Act. 217
Under the Investment Advisers Act, a person generally is not subject to registration with the Commission as an investment adviser if, during the last twelve months, the person has had fewer than fifteen clients and it does not hold itself out to the public as an investment adviser. 218 The Commission made clear in its May 1996 release that an adviser would not qualify for this "private investment adviser" exemption if it uses a publicly available electronic medium, such as a web site, to provide information about its services. 219
Certain entities provide investment advice on web sites that are not available to the public ( e.g. , web sites with effective pre-qualification and password-protection procedures). Some of these entities would not qualify for the private adviser exemption if they were considered to be "holding themselves out" to the public as investment advisers. In response to an inquiry by one of these entities, the Commission staff stated that investment advisers relying on the private investment adviser exemption may provide information about funds that they advise to a company that proposed to establish and administer a web site with information about privately offered funds. 220 The staff concluded that an entity that posts only private fund information on a web site that is not available to the public would not be "holding itself out generally to the public" as an investment adviser. 221 The Commission's May 1996 Release and this letter demonstrate how the Commission and its staff have responded flexibly to different uses of the same communications medium.
Communications between an investment adviser and its clients may take a number of forms. An adviser may, for example, (1) send to its clients information about suggested investments, (2) obtain consents from its clients under certain circumstances, 222 and (3) deliver written disclosure documents to its clients. 223 Investment advisers and their clients sometimes desire to send and receive this and other information using a media other than conventional mail, such as through electronic media. The Commission facilitated the electronic delivery of these types of documents in its May 1996 interpretive release. Consistent with investor protection, the Commission also stated in that release that investment advisers transmitting personal financial information 224 electronically should take precautions to ensure the integrity, confidentiality, and security of the information, independent of the medium used to send the information. The Commission also noted that precautions should be taken to ensure that information is reasonably secure from tampering or alteration.
As discussed in the prior chapter, mutual funds are placing a wide variety of information on their web sites, and the Commission is committed to ensuring that funds provide their investors with understandable information about their investments. As a result of the structure of the fund industry, a fund group's web site usually has information about both the funds in the group and their adviser. Under the Investment Advisers Act, an advertisement by an investment adviser is considered to be fraudulent, deceptive, and manipulative if the advertisement selectively refers to past specific recommendations of the adviser that were or would have been profitable to any person. 225 As part of their web site, a fund group and the funds' investment adviser proposed to publish information about the funds' recent portfolio purchase and sale transactions. The adviser asked the Commission staff whether the proposed publication of the information could be deemed to be an "advertisement" under the Investment Advisers Act, and thus subject to the above rule. The staff responded that the proposed publication of recent portfolio purchase and sale transactions made by the funds on a web site would not be an "advertisement" by the adviser under the Investment Advisers Act. 226
Computer technologies have been used by the investment management industry for many years. As early as the 1980s, the Commission recognized that computer technology could be used by investment companies and investment advisers to minimize certain regulatory burdens and to reduce the associated costs. 227 The Commission facilitated the electronic storage of certain records by investment companies and investment advisers by amending its rules to permit advisers and investment companies to maintain records on photographic film, magnetic tape, disk or other computer storage medium. 228
The growth of the Internet will continue to create challenges for securities regulators around the world. Investors searching the Internet have access to the web sites of investment advisers located both within and outside the investors' states and countries, whether or not the investment advisers are registered or qualified to do business in those jurisdictions. Because of the Internet's ability to reach investors worldwide, an investment adviser that uses a web site to offer its advisory services to prospective clients may inadvertently become subject to the law of multiple jurisdictions. To minimize any regulatory uncertainty that the uniquely global nature of the Internet may raise, the Commission and its staff are working with the investment advisory industry and with foreign securities regulators to analyze and resolve these issues.
The uses of new technologies by investment advisers are already quite diverse. The Commission has worked to facilitate the use of technologies that assist advisers to better serve their clients, while maintaining investor protection. As advisers, investors, issuers and others realize the potential of these technologies, advisers may change the nature of their services to satisfy the needs of their clients, and to take advantage of the newly-available resources. In the future, new technologies may change the fundamental structure and nature of the investment advisory industry. As more investors continue to take the initiative in using electronic communications and computer technologies to learn about their investments, investment advisers may need to find new types of services to attract and retain advisory clients, and provide those services in convenient and innovative ways.
U.S. securities markets have always quickly adopted new technologies that enhance information flow. In their time, the telegraph, telephone, and ticker tape all changed the manner and pace of securities trading. 229 More recently, computer technologies have come to play a critical role in the secondary markets. This chapter will discuss the regulatory context in which the markets operate, trends in the use of technology in the markets, and Commission initiatives to respond to evolving market conditions.
As computing power has become exponentially more powerful and comparatively inexpensive, technology has transformed the U.S. securities markets. Computerized systems have provided unprecedented opportunities for innovation and competition in market operations, speed and accuracy in processing trades, and creation of advanced portfolio and risk management techniques. In addition, technology has dramatically increased investor access to securities prices and other information.
Stock exchanges have automated a great many of their operations to improve their efficiency. Prior to the 1970s, processing a securities trade on the exchange floor was a manually intensive process. Generally an order received by a broker-dealer's registered representative at a branch office would be telephoned to the firm's order desk; the firm's order desk would telephone the firm's trading booth on the exchange floor and a firm representative (the floor broker) would take the order (a paper ticket) to the specialist location for the particular stock and execute a trade with either the specialist or other trading interest represented in the crowd. If the order was not executable ( e.g. , a non-marketable limit order), it was given to the specialist and hand-written into the specialist's book for future execution. The process of reporting the transaction back to the customer was substantially the same in reverse. 230 During the 1960s, this process had begun to break down under the pressure of increasing order flow. By April of 1968, the exchanges were forced to curtail trading hours so that brokerage firm back-offices could handle the backlog of paper. 231 This prompted exchanges to develop computerized systems for order delivery and execution. Increases in trading volumes also prompted the automation of other SRO functions, such as the dissemination of transaction and quotation information, specialists' limit order books, and the comparison of trades prior to settlement.
Broker-dealers have also automated many of their operations, both by purchasing or leasing systems and services from vendors, and by building proprietary systems using in-house technology staff. Similarly, institutional investors have become more active in managing their portfolios, and have demanded the technological tools to be more competitive with market professionals. Individual investors today are increasingly interested in managing their own investments, 232 and with the increasing popularity of the Internet, retail investors can now obtain easy and inexpensive access to real-time market information, analytic programs and electronic trading.
Because of the nature of its oversight of the secondary markets, the Commission has been in a position to closely observe automation trends in the industry and evaluate the impact of technology in secondary market trading. Overall, automation has enhanced operation of the secondary markets, and markets and market participants have used technology to create innovative solutions to problems. In addition, in many areas, the adoption of advanced technologies by markets and market participants has facilitated compliance with regulatory requirements. Nevertheless, the rapid pace of change in this highly computerized environment has also resulted in new tensions. In its approach to the changing environment, the Commission has remained committed to facilitating resolution of the challenges the industry may face in attempting to incorporate new advances into current operations while responding to changing market and regulatory developments.
Regulation of securities markets ensures, to the extent practicable, that markets are fair, open, efficient, transparent, orderly and competitive. The Commission oversees the operation of the nation's securities markets and market participants 233 under the provisions of the Exchange Act. 234 The Exchange Act charges the Commission with establishing and maintaining standards for fair, orderly and efficient markets, primarily through the supervision and regulation of major market participants such as brokers and dealers, exchanges, clearing agencies, transfer agents, and securities information processors.
Self-regulatory organizations ("SROs") such as exchanges, clearing agencies and the National Association of Securities Dealers ("NASD") play a significant role in regulating the U.S. securities markets. SROs are membership organizations that are granted special rulemaking authority under the Exchange Act to assist the Commission in its oversight of the securities industry. SROs such as the NASD and the exchanges 235 are responsible for establishing, reviewing and enforcing standards of conduct for their members and, if they provide trading facilities, for fair and orderly operation of those facilities. In practical terms, this means that SROs must establish and administer rules governing sales practices, trading and business practices, member financial responsibility, as well as enforcement of those rules and the federal securities laws. While SROs provide one level of regulation for the industry, the securities laws give the Commission significant direct regulatory authority over markets and market participants. The Commission's regulatory program for the secondary markets focuses on the registration of market participants; approval of SRO rules and policies; oversight and approval of rules and policies governing the collection and dissemination of quotation and price information; adoption and application of financial responsibility rules for broker-dealers ( i.e., net capital and customer fund segregation); and rules governing trading in the secondary markets, such as anti-manipulation, short selling, and customer confirmation rules.
In its oversight of the secondary markets, the Commission has sought to promote competition, foster innovation, and protect investors. The Commission has long maintained that transparency ( i.e. , the public dissemination of trade and quote information) plays a fundamental role in the fairness and efficiency of the secondary markets. 236 As early as 1963, the Commission recognized the role technology might play in improving market transparency. In its Report of the Special Study of Securities Markets, 237 the Commission noted that "[w]ith an already strong communications network, there is on the horizon the likelihood of a computer system that would assemble all interdealer quotations for particular securities at any given time." 238 The Commission urged the NASD to create such an electronic display system. 239 Similarly, in its 1972 Statement on the Future of the Securities Markets, the Commission called for a comprehensive system to make information on securities sizes, volumes and prices available to all investors. 240 In the Securities Act Amendments of 1975 ("1975 Amendments"), 241 Congress endorsed the concept of a "National Market System" that at its core would be composed of electronic communications systems, and clarified and strengthened the Commission's authority to promote the development of such a system. 242
Through a coordinated effort, the SROs developed the Consolidated Transaction Reporting Association ("CTA") and the Consolidated Quotation System ("CQS") in 1974 and 1978, respectively. These systems provide for the electronic collection and dissemination of real-time trade and quotation information in all exchange listed and OTC securities. 243 Under these plans, quotation and trade reports are submitted electronically to a central processor, the Securities Industry Automation Corp. ("SIAC"). 244 SIAC, in turn, processes this information and broadcasts it to financial information vendors for dissemination to investors. In 1978, the SROs developed the Intermarket Trading System ("ITS") to facilitate intermarket trading in exchange-listed equity securities based on the current quotation information emanating from the linked markets. By linking the exchanges and the over-the-counter ("OTC") market, ITS enables a broker or dealer who is physically present in one market center to execute orders, as principal or agent, in an ITS security at another market center. 245 These three electronic communications systems (CQS, CTA and ITS), along with the Nasdaq Stock Market and the OTC-UTP plan, 246 form the backbone of the National Market System for securities.
Over the past five years, U.S. securities markets have experienced a tremendous growth in trading volume. In 1992, the average daily share volume on the NYSE was approximately 178.9 million shares. For the first part of 1997, average daily share volume has been approximately 501.9 million shares. Nasdaq has experienced similar growth: in 1992 Nasdaq average daily share volume was approximately 190.8 million shares per day; for the first part of 1997, Nasdaq share volume has averaged 607.9 million shares per day. 247 Recent advances in technology, in particular automated order routing and execution functions at the exchanges and Nasdaq, have made possible much of this growth.
Most registered exchanges still rely on traditional trading floors to bring together buyers and sellers; 248 however, all exchanges continue to automate many of their services to increase the efficiency of their operations. For example, all exchanges have automated their floor trading posts and specialists' limit order books. In addition, as noted above, all exchanges have systems that allow members to electronically route orders to the floor of the exchange. 249 The NYSE is currently implementing a $125 million technology initiative, the "Integrated Technology Plan ("ITP"). 250 Changes to the NYSE floor resulting from this initiative include, among other things, a new trading floor communications network which will enable a specialist or broker to integrate order-management functions and market information from multiple sources on to a single screen; wireless voice telecommunications devices ( e.g. , cellular telephones) that provide continuous communications between brokers anywhere on the floor and their firms' booths on the floors' perimeters; and wireless data devices ( e.g. , hand-held terminals) that allow floor brokers to receive orders and send reports while remaining at the floor auction sites. 251
Other exchanges are undertaking similar initiatives. The Chicago Board Options Exchange ("CBOE") has recently begun a multi-year plan to revamp its technology infrastructure, including replacing the traditional paper trading cards with a wireless communication system. CBOE currently supports approximately 350 hand-held market maker terminals on its trading floor, and plans to increase the number to 800 by 2000. 252 The Amex has also permitted members to use wireless data communications devices to communicate with one another from different points on the trading floor. 253 Wireless networks afford floor personnel more flexibility, are less expensive, and are faster than traditional methods of communication, which include hand signals, telephones and floor reporters. Because there are fewer people involved in a wireless transaction, there is less chance for error. 254 The exchange's wireless initiatives are designed to process more order flow in an electronic system, thereby reducing errors, improving the post-trade processing to reduce financial risk, and making greater use of software to improve brokers' order management capabilities. 255 Currently, most wireless trading takes the form of exchanges permitting firms to independently use their own hand-held terminals. However, like the NYSE, exchanges are taking action to provide support for these member systems and to establish exchange wide systems. For example, the Amex has built a common antenna to handle all wireless communications on its floor, and plans to move member firms from their own networks to one operated by the exchange. The Amex also intends to offer members hand-held trading terminals. 256
Some exchanges have added electronic trading systems to supplement floor trading. In 1994 the Chicago Stock Exchange ("CHX") developed the now-defunct Chicago Match System, which electronically crossed orders entered by users during regular trading hours for securities traded on the CHX. 257 Orders matched electronically were priced and executed at the market price (equal to the midpoint between the national best bid and offer) at a random time within a pre-determined ten minute period. On September 17, 1997, the Commission approved a proposal by the Pacific Stock Exchange to offer an electronic trading system developed by OptiMark Technologies Inc. to its specialists and floor brokers. 258 The OptiMark System is designed to match traders' "satisfaction levels" regarding a variety of prices and sizes to establish the "optimum" price for execution.
One exchange, the Cincinnati Stock Exchange ("CSE"), has replaced its trading floor with a fully automated trading system. Trading on the CSE is conducted through the National Securities Trading System ("NSTS"), which is an electronic securities communication and execution system through which bids and offers of public orders and competing dealers are consolidated for review and execution. The NSTS enables CSE members to participate in the system by entering into computer terminals bids and offers for securities for their own account and as agent for their customers' accounts without the necessity of maintaining a presence on the floor of any other exchange. 259
Traditionally, dealer markets have consisted of loosely organized groups of individual dealers that traded securities OTC, without formal consolidation of orders or trading. However, Nasdaq now consolidates trading interest of multiple dealers on a computer screen that is displayed real-time to its members, and provides a mechanism for dealers to update displayed quotes. In addition, Nasdaq offers two services, SelectNet and the Small Order Execution System ("SOES"), 260 that allow electronic trading. However, Nasdaq is not a completely automated market. With the exception of the SOES and SelectNet features, order entry and execution for Nasdaq still largely occurs by telephone. As a result, proprietary trading systems, which execute transactions automatically, have been able to capture significant volume in Nasdaq stocks. 261
Companies quoted on Nasdaq must meet certain qualitative and quantitative criteria; however, there are a number of publicly traded companies that do not meet Nasdaq or exchange listing requirements. Quotes for these non-Nasdaq OTC companies are published daily by the National Quotation Bureau Inc. in the "pink sheets." Nasdaq also operates an electronic quotation service for these stocks, the OTC Bulletin Board. The OTC Bulletin Board displays real-time quotes and last sale prices for nearly 6,000 companies. However, unlike the issuers quoted on Nasdaq, these companies are not subject to any financial or reporting criteria prior to inclusion on the OTC Bulletin Board.
Like the NYSE, Nasdaq has undertaken a major project to up-grade its computer operations. In 1996 Nasdaq completed installation of a new computer system and telecommunications network, which included replacing its computer platform and workstations. Nasdaq is already planning to develop a new communications network to further increase its system capacity. 262 It is currently constructing a new $33 million data center, and plans to develop a new communications network to increase its system capacity.
OTC trading of exchange-listed securities is commonly known as "third market" trading. In the 1990s, third market trading has increased, principally from operations established by a few third market markers to handle small customer order flow. The third market makers act much like Nasdaq market makers in that they accept orders of up to a few thousand shares in the most active listed stocks from retail firms or discount brokers. Market orders are executed against the best bid or offer on ITS, and limit orders are handled according to preestablished execution parameters. 263 The third market has grown significantly in the last few years, from about 2% of NYSE volume in 1979-80 to over 7% of NYSE volume in 1996. 264
Third market makers rely heavily on technology to conduct their business. 265 Third market makers receive orders electronically and route them to different execution points depending on whether they are market or limit orders. Some third market maker systems include price improvement algorithms that execute customer orders at prices better than the prevailing market quotes under certain market conditions. Orders are generally executed against the third market maker's proprietary orders. Trades are generally reported immediately to the NASD's Automated Confirmation Transaction Service.
Broker-dealers route orders to third market makers for a variety of reasons. First, most third market makers do not charge commissions but instead give rebates to the brokers that route orders to them in the form of payments for order flow. 266 Second, these systems often provide very fast executions compared to some exchanges where market order turnaround can take longer. 267 Third, price improvement algorithms allow firms to provide customers with executions that are as good as they would have obtained on the primary market.
Clearing agencies have incorporated automated systems into their operations to streamline operations and reduce risk. NSCC, 268 which clears and settles close to 99% of all stock and bond trading in the U.S., over time has developed a variety of post-trade automated services designed to increase efficiency, minimize risk, and reduce costs. The Options Clearing Corporation ("OCC") 269 has also computerized major systems to reduce risk during clearance and settlement. For example, the OCC has developed the Theoretical Intermarket Margin System ("TIMS"), which is a sophisticated, risk-based automated methodology for calculating margin; 270 the Options Automated Settlement Instructions System, which is an electronic notification and approval system for settlement processes; and the Risk Management System, which is a sophisticated risk analysis program designed to help OCC clearing members and exchanges manage the risk of their customers and members in the same manner that OCC manages its risk. In addition, OCC is currently developing a new clearing system, NxTRACSTM, which will provide on-line, real-time trade capture, intraday margin calculations based on the most current positions and prices, and an integrated data entry and inquiry interface that is expected to minimize data entry errors. 271 NSCC has established the Collateral Management System ("CMS"), which provides participating clearing entities and firms that maintain memberships at multiple clearing entities with information regarding excess capital, clearing fund deposits, and margin deposits on a real-time basis through an electronic display. 272 CMS helps clearing agencies and their participants better monitor clearing fund, margin and other required deposits that protect a clearing agency against loss should a member default on its obligations to the clearing agency. 273
Many recent developments in the securities markets designed to reduce systemic risk are possible because of recent advances in technology. One example is shorter settlement cycles. 274 As markets and market participants implement straight-through processing, 275 it will be possible to reduce settlement cycles even further. Similarly, the high degree of automation that already existed in securities payment systems made possible the industry's conversion from a next-day funds settlement system for securities transactions and principal and interest payments to a same-day funds settlement system ( i.e. , payment must now be made in funds that are immediately available and final at the time of payment). The same-day funds system reduces systemic risk by eliminating overnight credit risk and by achieving closer conformity with the payment methods used in the derivatives markets, government securities markets and other markets. 276
The markets for debt securities ( i.e. , Treasury securities, municipal bonds and investment grade and high-yield corporate bonds) have trailed the equity markets in the use of technology. Many participants still prefer conducting business with a "live person" by telephone and fax machine. 277 The use of technology in the debt markets has been highly dependent on the willingness of the individuals involved to make a change to electronic trading. Many traders have become accustomed to and prefer the telephone and fax machine as a way of doing business due to the personal interaction involved. 278 One of the biggest hurdles to increased electronic trading of debt is liquidity. Until enough market participants are willing to trade electronically, there will not be enough volume to support larger trades and not enough interest to attract customers. 279 The landscape for trading debt securities is slowly changing, however. A survey released by The Bond Market Trade Association showed that almost two-thirds of respondents believed that within two years, most dealers will offer electronic bond trading systems to institutional customers. 280
Most bonds trade OTC; 281 however, a small number of debt securities (mostly investment grade corporate bonds) are exchange-traded. The exchanges have automated systems that support bond trading. The NYSE, for example, uses a system called the Automated Bond System ("ABS") to support corporate bond trading. Subscribers 282 can participate in the bond market using proprietary terminals that provide current quotation and trade information for bonds listed on the NYSE. The ABS also allows electronic order entry and automatically executes trades for matching buy and sell orders. In addition, Nasdaq operates the Fixed Income Pricing System ("FIPS"), a screen-based system that collects, processes and displays quotes and summary transaction information for certain high-yield corporate bonds to NASD members participating in the system, and publicly through market data vendors. 283
The Treasury market has historically used computer technology only for the purpose of allowing dealers and brokers to transmit indications of interest to each other. In these so-called "interdealer brokerage systems," order entry and execution are still done by telephone and fax, but dissemination of indications of interest are done by computer. Generally, each broker maintains a proprietary system between itself and its dealer customers. Various dealer customers of a specific broker transmit indications of interest by telephone or fax to buy and sell specific bonds at specific quantities at specific prices. The broker enters these indications into the computer system manually. Every dealer can use its monitor, connected to the broker's proprietary network, to see the indications of interest. The best bids and offers that each brokerage has to offer for each particular debt instrument are disseminated to the market and displayed on dealers' monitors anonymously. If there is a dealer wishing to sell and a dealer wishing to buy the same bonds for the same price in the same amount, there is no automatic order execution. The broker usually makes each party aware of the other's interest or the dealer has to call the broker and express its desire to make a trade. 284
Some broker-dealers have developed electronic systems to display their Treasury security, corporate bond or municipal security inventories. 285 Clients can review the inventory and then enter orders by phone or by computer. A few broker-dealers have established alternative trading systems for Treasury, corporate, and municipal securities. These systems have had limited success to date. According to one estimate, trades executed through alternative trading systems represent less than 1% of overall trading volume in the bond market. 286
In addition to electronic trading, technology is being used to enhance the transparency of debt markets. Data on all completed transactions in the government debt market are reported to GovPx which, in turn, markets composite information to subscribers for a fee. This centralized reporting and dissemination system produces an extremely transparent government securities market. In the corporate debt markets, bonds that are traded on exchanges are reported, but most corporate bond transactions take place in the OTC market. 287 This produces a market where there is transparency with respect to only a portion of the corporate bonds traded.
In the municipal securities markets, there was no automated system for public reporting of municipal securities transactions and no industry-wide audit trail of transactions prior to 1995. The Municipal Securities Rulemaking Board is in the process of implementing an automated transaction reporting system that will bring these capabilities to the municipal securities market. The system is designed to accept transaction data from dealers and will generate daily reports that summarize price and volume information for frequently-traded municipal securities. The system also is designed to create a comprehensive database of municipal securities transactions that will provide a transaction audit trail for use by regulators. The first phase of the transaction reporting system has collected and reported on inter-dealer transactions in the municipal securities market since January 1995. 288 Dealer-customer trades are scheduled to be included in the system on January 1, 1998. 289
The Commission has maintained flexible and open policies designed to encourage innovation in the secondary markets. As a result, a number of market participants (usually broker-dealers) have developed computerized "alternative trading systems" ( i.e. , systems that centralize, display, match, cross or otherwise execute trading interest). 290 Instinet Corporation, which began operating a computer network for professional investors to effect block trades in 1969, currently operates the largest alternative trading system, the Real-Time Trading Service. Other alternative trading systems currently operating include Bloomberg Tradebook LLC's Tradebook, Island, ITG Inc.'s Portfolio System for Institutional Trading ("POSIT") and the Arizona Stock Exchange ("AZX"). 291
Over the past 30 years, the Commission has explored various ways to respond to the activities of these alternative trading systems that would protect the markets, while at the same time encourage innovation. Generally, as a baseline, the Commission has regulated such systems as broker-dealers, rather than exchanges. 292 The Commission avoided requiring alternative trading systems to register as exchanges because it had limited authority to tailor exchange regulation to diverse market structures, and because the number of alternative trading systems and their trading volume was relatively small. In light of these limitations, the Commission believed that regulating alternative trading systems as exchanges would stifle the development of such systems. 293
Nevertheless, the Commission recognized the short-comings of customary broker-dealer regulation for alternative trading systems, 294 and proposed additional market oriented requirements on several occasions. 295 Recently, the National Securities Markets Improvement Act of 1996 296 provided the Commission with considerable authority to exempt markets from provisions of the Exchange Act. Given this expanded authority, the Commission revisited the issue of whether classification as an exchange would stifle innovation, and has published a release soliciting comment on proposals for establishing a consistent, long-term approach to the regulation of alternative trading systems. 297
Information vendors receive data feeds from the markets (or, in the case of U.S. markets, exclusive securities information processors such as SIAC), and then package that data with a user interface. Fifteen years ago, market data providers serviced different market segments; for example, traders would rely on Quotron for U.S. equities prices, Telerate for fixed-income prices, and Reuters for foreign exchange information. 298 However, as different markets have become interconnected, and as the number of information sources has grown, market participants have come to demand integrated information rather than specialized data. While different vendors still have strengths in particular instruments, market forces are compelling them either to offer a wider variety of data or to make their systems open so that clients can use multiple vendor services at one workstation.
As a result of these pressures, vendors have developed "value-added" products and connectivity services. 299 In addition to data feeds from the U.S. exchanges and Nasdaq, many vendors also provide quote information from foreign markets. Most also provide historical data and sophisticated analytical tools, order routing systems, and trading screens. Vendors have also added services that will link investors' computer systems with broker-dealers' systems and link front and back office systems. In addition to market data services, vendors may also now provide order management and routing, securities transaction processing, investor support tools, and investor communications related services to the investment and brokerage community. 300 Other services might include sophisticated quantitative models to help portfolio managers assess risk and select stock. 301
Broker-dealers and institutional investors have become substantial consumers of technology. 302 Powerful computer systems, sophisticated analytic programs, data feeds from markets and news services, comprehensive databases of market data, electronic links to the markets and to each other, and automated trade support systems have become essential components of the financial services business.
Most broker-dealers use powerful microcomputers (called workstations) to support their market making and brokerage functions. These workstations allow individual users to simultaneously perform multiple trade support functions, such as order management, monitoring net long or short positions in specific securities, calculating profit or loss real-time, analyzing risk and receiving market data. 303 Other trade support functions include trade reporting, records of completed transactions, links to back-office systems and order routing to various execution points. 304 Market makers also use these systems to monitor inventory and published bids and offers, automatically adjust inventory to reflect completed transactions and alter bids and offers. In addition, some broker-dealers provide order transmission capabilities to their registered representatives, correspondent broker-dealers or customers to permit them to electronically transmit all relevant information concerning an order to the broker-dealer's trading desk.
Some firms have built their own trade support systems; other firms purchase or lease systems from vendors. 305 These vendors may also function as service bureaus, i.e. , operating the computers on which the systems run, and managing the software for the client. As noted earlier, the exchanges have all developed electronic systems through which members can transmit orders directly to the floor. A firm might work directly with the exchange to create this link. However, there are also vendors that will provide the link between broker-dealers and multiple exchanges through one interface. 306 While not a major trend, brokerage firms are increasingly outsourcing their technology operations, including their trading systems. 307 As trading has become more dependent on technology, the investment community has found itself investing increasing resources on system development. By outsourcing, firms save the expense of employing data processing and systems development personnel, and maintaining the physical computer facility. 308
Like broker-dealers, institutional traders are beginning to use order management systems to track their trading positions. Order management systems also are used by institutions to automate the transmittal of paper order tickets internally from the portfolio manager's order desk to the buyside trader to create a seamless workflow. 309 This integration provides more timely executions and reduces errors caused when information regarding a single trade must be reentered into different systems. The systems that internally route a trade from the portfolio manager to the institutional trader may also, over a series of either dedicated lines or public networks, send the order to the institution's broker-dealer. Confirmations of trades can then be sent back to the institutional trader, ultimately reaching the portfolio manager at the end of the process. 310
Institutional investors have come to rely on information feeds and analytic packages to support their trading decisions, and software to allocate securities positions into individual accounts. In addition, most institutions want immediate price information from broker-dealers, and value the ability to route orders electronically to the broker-dealer. A number of new businesses have developed in the past 10 years to satisfy these demands. Institutions can choose from a variety of software packages that provide analytic and accounting programs for institutional money managers. Also, institutions can subscribe to services like AutEx 311 and GovPx 312 , which disseminate broker-dealers' "indications of interest" to trade. AutEx and GovPx both have a message capability, so that institutions can negotiate with brokers posting on those systems. Institutions also participate directly in alternative trading systems such as Instinet. 313 In addition, vendors have established systems to provide general order routing links between institutional traders and broker-dealers. 314
Institutional investors are demanding connectivity between their systems and broker-dealer systems or other points of execution. Initially, vendors wrote proprietary applications for accessing their services that were not compatible with services offered by other vendors' products. Institutions, however, want to connect with multiple broker-dealers through an integrated system. Rather than wait for vendors to develop a standard protocol for transmitting messages from their order management systems on the buyside to their brokerages, industry executives developed their own transmission protocol, the Financial Information eXchange protocol, or FIX. 315 The FIX protocol is a message standard developed to facilitate the electronic exchange of data related to securities transactions, including indications of interest, orders, fills, executions, allocations and confirmations. FIX is not dependent on any particular system architecture or platform to operate, permitting previously incompatible systems to exchange information electronically. 316
A significant trend in the industry is a move towards "straight-through processing," or the complete automation of trade processing, from pre-trade indications through post trade processing and on to settlement. 317 A major step towards achieving straight-through processing will be the seamless integration of many different post-trade processes, including allocation, trade comparison, and clearance and settlement. The widespread adoption of the FIX protocol is an important step towards achieving such integration.
In the past two years, markets and market professionals have embraced internet technology to enhance communications networks already in place. For example, securities firms have begun using internet technologies, in particular TCP/IP, for intranets. With intranets, firms can create information repositories that are easily accessible enterprise-wide. Firms are also beginning to provide institutional clients access to these intranets by "extranets." Although some firms are using the Internet to communicate trading interest to their institutional clients and other market professionals, many are reluctant to use the public network for this type of business because of performance and security concerns. Nevertheless, broker-dealers are using the Internet to market themselves to potential clients. In a survey conducted among 230 securities firms, the SIA found that 100% of firms with more than 4000 employees and 84% of firms with between 500 and 4000 employees have Internet sites. 318
Broker-dealer web sites serve a variety of functions. First, they advertise the broker-dealers' services to potential investors. They may also offer market information and investment tools similar to those offered by information vendor or SRO web sites. Some broker-dealers' web sites offer real-time or delayed quote information, continuously update quotes while the user visits other sites, or allow investors to create a personal stock ticker. Some also provide market summaries and commentaries, analyst reports and trading strategies and market data on currencies, mutual funds, options, market indices and news. In addition, there are also a number of broker-dealers who offer investors access to portfolio management tools and analytic programs. A typical site will include information on commissions and fees, branch office locations, and states in which the broker-dealer is qualified to do business. Full-service brokers emphasize the availability of account information and research reports, and, in some cases, provide their registered representatives with their own homepages. A small number of broker-dealers, usually discount brokers, allow investors to access their account information and enter orders to purchase or sell securities on the Internet.
Of all the financial services offered over the Internet, on-line stock trading has received the most publicity. The ability of retail investors to trade by computer is not new, however. In the 1980s, several broker-dealers began offering retail customers proprietary software and direct dial-up access that permitted them to submit orders by personal computers. By 1990, these broker-dealers claimed at least 70,000 users. 319 Today, approximately 1.5 million customers are reported to have on-line brokerage accounts. 320 Yet overall, only a relatively small percentage of retail customers use the Internet for securities trading. In a survey of 1,500 individual investors, the SIA found that 7% used computers to make investment trades. 321 Of this 7%, only 20% made all of their trades by computer; the majority of investors made less than half their trades using a computer. On the other hand, 26% of investors who do not currently use a computer to trade report that they are "very likely" or "somewhat likely" to do so in the next 12 months, while 32% reported that they will definitely not use a computer to trade.
Approximately thirty broker-dealers currently offer on-line trading. Most of these are discount brokers and offer customers who trade exclusively over the Internet substantial discounts on commissions, even as compared to a traditional discount brokerage account. 322 At least one broker-dealer has announced plans to offer full-service brokerage targeted at its current client base, with the same fee structure. 323 The number of firms offering on-line trading will likely continue to grow, as compliance and security issues are resolved. Most broker-dealers require their customers to use an Internet browser that supports encryption, considering this level of encryption to be sufficient to protect their information flows. Another area of concern is system capacity. As the number of customers entering orders on-line grows, broker-dealers may find that their systems are inadequate to meet demand during peak trading hours or when the market is volatile. The safety and integrity of customer accounts is an important investor protection concern and the Commission staff is monitoring the development of on-line systems and their use of encryption and other security technologies.
At this point, broker-dealer Internet trading facilities are simply order-routing systems, rather than alternative trading systems that provide for matching or crossing of orders within the system. Typically, a broker-dealer offering Internet trading facilities to its customers provides an electronic template for the customer to enter the name of the security, whether it is to be bought or sold, the quantity and whether the order is a market or limit order. Once the broker-dealer receives this information, it is checked electronically against the customer's account, and barring a discrepancy such as a "sell" order for a security the customer does not own or a lack of available funds for a "buy" order, is routed out of the broker-dealer within a matter of seconds to the appropriate exchange or a market maker for execution. After the order is executed, the customer receives a message confirming the order. In many cases, the customer's portfolio will also be updated on-line to reflect the transaction. 324
At least one broker-dealer has announced plans to offer an alternative trading system for retail customers trading on its Internet site. 325 It is likely that other internal broker-dealer trading systems will be developed. Also, technology, the Internet in particular, has made feasible after-hours trading systems for retail investors. The Commission staff is evaluating developments in this area, and through its examination program, is reviewing the operations of on-line trading systems.
Individual investors use the Internet primarily for research and market data. One survey found that 35% of investors used computers to obtain investment information. 326 A second survey found that 26% of investors obtain investment information on-line. This latter survey also indicated that young investors (age 18 to 34) rely on on-line media as an information source at much higher rates (45%) than older investors. 327
Investors may subscribe to a variety of services offering access to real-time market data, company profiles and earnings reports, mutual fund data, and news services over the Internet. In addition, most of the country's leading commercial on-line services receive data feeds from information vendors to provide to their users. These services may also offer tutorials on trading strategies or mutual fund investing, as well as services that allow investors to chart historical data, monitor portfolios, receive e-mail notice of price moves and screen mutual funds for those that match specified criteria.
In addition, many SROs have established their own web sites through which they provide a variety of tools and services to the investing public, including quotes, e-mail addresses for questions, Frequently Asked Questions files, complaint registration mechanisms and general information. 328 For example, the NYSE web site contains the "Interactive Education Center," which includes a virtual tour of the NYSE trading floor and an explanation of the "how's and why's" of the NYSE market system. The NASD sponsors the "Individual Investor Services" homepage, which provides investor training, market data, financial calculators and access to sources for additional information. The Chicago Board Option Exchange's "Education" section has extensive information about options, geared for use by investors with varying levels of trading experience. A number of clearing agencies have web sites that include information about the sponsor and its activities, as well as explanations about the clearance and settlement process generally. 329 In addition, the Municipal Securities Rulemaking Board's web site provides access to detailed information about its role and function, as well as a guide to municipal securities generally. 330
Recently, the Commission has undertaken a number of initiatives that relate to the use of technology in the marketplace, and how that technology has changed the way markets and market participants operate. At the same time, the Commission has tried to be receptive to industry requests for guidance regarding how to administer regulations adopted in a paper-based environment in light of the development of new technologies, and has attempted to modify rules or interpretations that may inhibit use of technological innovations.
Recent advances in technology permit a variety and combination of services, which blur the distinctions between markets, intermediaries, and service providers. For example, some registered broker-dealers provide an automated, screen-based network through which participants can enter orders or execute trades against orders entered by others. Like traditional exchanges, these systems centralize orders and give participants control over the interaction of their orders. 331 Information vendors now also provide many of the services historically provided by exchanges or broker-dealers. For example, as noted above, many information vendors now offer electronic order routing services as well as financial product data. In addition, some vendors offer trading systems that connect market intermediaries with their clients. These systems are sponsored by particular broker-dealers, and are available only to that intermediary's customers. Generally, they enable customers to view the intermediary's inventory, electronically route orders to the intermediary for execution, and receive confirmation of the trade by the vendor's network. 332 In addition, information vendors offer services that route orders between market participants and send clearance and settlement information to clearing corporations.
The Exchange Act, however, relies on definitional distinctions to determine the obligations and responsibilities of each entity towards customers and the market as a whole. In particular, the Exchange Act regulates market participants based on their activities, such as an "exchange" function or a "broker-dealer" function. Although the Exchange Act defines terms such as "exchange," "broker-dealer" and "securities information processor" 333 broadly, until the recent addition of exemptive authority, it did not easily accommodate hybrid entities.
Additionally, technology has eased geographical barriers to cross-border trading. Until recently, in order to obtain current information regarding foreign market prices or to purchase or sell a foreign security, a U.S. investor typically would contact a U.S. broker-dealer by telephone or facsimile. The U.S. broker-dealer would then give the U.S. investor current information and transmit the investor's order to a member of the foreign market on which the security was traded. Alternatively, the U.S. investor could contact a foreign broker-dealer directly. Today, however, it is possible for U.S. investors to obtain real-time information about trading on foreign markets from a number of different sources, and to enter orders electronically from the U.S.
Many foreign markets are now electronic, and thus members can trade on those markets without being physically present on the market "floor" or establishing a physical presence in a market's home country. As a result, several foreign markets have begun to offer remote access to members. 334 In recent years, several foreign markets have proposed permitting U.S. broker-dealers and institutional investors to become market members through remote access arrangements. Such arrangements, however, raise significant issues under the federal securities laws. Most securities traded on foreign markets are not registered under the Securities Act or the Exchange Act, and the issuers of those securities do not file reports with the Commission. Also, the federal securities laws provide no clear guidance regarding the regulatory status of foreign markets that provide remote access to U.S. persons, in particular whether such access would require foreign markets to register as national securities exchanges.
On May 23, 1997, the Commission authorized the publication of a concept release that, among other things, solicits comment on a broad range of questions concerning the oversight of alternative trading systems, U.S. securities exchanges, and the activities of foreign markets in the U.S. 335 The purpose of the Exchange Act Concept Release is to initiate a dialogue as to how to develop a regulatory framework that provides sufficient flexibility to ensure market fairness, efficiency, and transparency, while at the same time fostering innovation.
During the past 20 years, U.S. investors and markets have greatly benefited from advances in technology and the resulting growth of alternative trading systems. Although these trading systems represent comparable alternatives to traditional exchange trading, as noted above, for historical reasons they are regulated as broker-dealers and are not fully integrated into the mechanisms that ensure market transparency, fairness, and oversight.
Because of the increasing impact of alternative trading systems on U.S. securities markets, the Commission has begun to examine ways to improve the transparency, fairness, and oversight of trading on these systems. The Exchange Act Concept Release solicits commenters' views on how best to accomplish these goals. One of the alternatives discussed in the Exchange Act Concept Release would use the Commission's new authority under the National Securities Markets Improvements Act of 1996. This exemptive authority would allow the Commission to craft an appropriate level of regulation for alternative trading systems, integrating these systems into the national market system without requiring them to comply with unnecessary and inappropriate requirements. In addition, the Exchange Act Concept Release examines ways for the Commission to use its new exemptive authority to facilitate the ability of registered exchanges and the NASD to use technology to respond to competitive pressures.
The Exchange Act Concept Release also seeks comment on possible regulatory schemes for foreign electronic exchanges that do business with U.S. investors. As noted above, technology may now allow U.S. persons to trade directly on foreign markets from the U.S.; however, the Commission has not addressed the regulatory status of entities that provide U.S. investors access to foreign markets. As a result, many foreign markets have been reluctant to provide these services directly to U.S. investors. The Exchange Act Concept Release discusses various approaches for addressing foreign market activity in the U.S., including requiring foreign markets that seek to enter the U.S. to register with the Commission as national securities exchanges, or relying solely on home country regulation of the foreign market. 336 The Exchange Act Concept Release also suggests an intermediate approach. Under this intermediate approach, the Commission could establish regulatory requirements for entities that provide U.S. persons with direct access to foreign markets ("access providers"), regardless of whether these entities are registered in the U.S. Access providers could be required to comply with limited recordkeeping, reporting, and disclosure requirements, as well as the anti-fraud provisions of the federal securities laws. The Commission could also permit access providers that are registered as U.S. broker-dealers to provide both retail and sophisticated investors with electronic links to foreign markets. This approach might provide adequate protections to U.S. investors trading on foreign markets, while facilitating greater transparency.
The Exchange Act Concept Release is intended to commence a dialogue with, and to elicit the views of, the industry and the public regarding ways to update the Commission's regulatory framework to address recent changes in the U.S. securities markets resulting from technological developments. While the Exchange Act Concept Release solicited comment on the challenges posed by alternative trading systems and foreign markets operating in the U.S., the Commission recognized that these approaches are not exclusive and in the Exchange Act Concept Release broadly requested comment on how best to achieve the goals of the securities laws.
Amid growing concern about the handling of customer orders for securities by specialists and market makers, and in light of the development of sophisticated technological systems for displaying and routing customer orders, last year the Commission adopted rules designed to increase the transparency and improve opportunities for the best execution of customer orders ("Order Execution Rules"). 337 New Rule 11Ac1-4, the "Limit Order Display Rule," requires exchange specialists and OTC market makers to immediately display in their bid or offer both the price and the full size of each customer limit order that would improve their quoted price in a particular security, subject to certain exceptions enumerated in the rule. 338 The Commission also amended Rule 11Ac1-1, 339 the "Quote Rule," to require a market maker to publish quotations for any listed security when it is responsible for more than 1% of the aggregate trading volume for that security, and to make publicly available any superior prices that a market maker privately quotes through certain electronic communications networks ("ECNs"). 340 Under this "ECN Amendment" to the Quote Rule, market makers and specialists are required to make available to the public the price of any orders they place on an electronic network if the price is better than their own public quotation, either by accounting for these orders in the public quote, or by making the private network publicly available by linking them to the major markets. The new rules permit an ECN to fulfill these obligations on behalf of market makers using its system by submitting its best bid/ask quotations to an SRO for inclusion into public quote displays. Four of these private networks 341 have received confirmation from the Division of Market Regulation that they qualify as ECNs as defined in the newly adopted rules, and will be in compliance with the requirements applicable to the ECN Display Alternative set forth in the Quote Rule. 342 The rules were intended to enhance market transparency, improve access to the best available prices, and foster competition. The Order Execution Rules became effective on January 21, 1997. Recent data compiled by Nasdaq regarding the rules indicates that quoted spreads have declined substantially since implementation of the rules. 343
Beginning in the late 1970's, the financial markets have witnessed tremendous growth in the development and trading of derivative products. 344 Derivatives trade both on exchanges and over-the-counter. "OTC derivatives" are generally privately negotiated, customized contracts designed to meet the specific needs of counterparties. 345 As customer demand for such products grew, market professionals responded by using advances in financial theory and computer technology to develop innovative and complex derivative products. 346
Derivatives can provide significant benefits to corporations, financial institutions and institutional investors. 347 However, the use of derivative products has raised concerns that the complexity and leverage inherent in these instruments, along with their tendency to link different market segments, might pose risks to individual firms and to the markets in general during periods of market disruption. 348 Evolving portfolio and pricing technologies have permitted the engineering of increasingly complex financial instruments which have risk profiles that are difficult to analyze. At the same time, the industry has begun using powerful computer systems to analyze and manage risk.
Risk management systems have grown over the past five years into complex systems capable of managing historical data and providing real time reports that integrate information concerning multiple departments and operations. 349 In addition, broker-dealers are increasingly relying on statistical models as a method of analyzing, controlling, and reporting the amount of market risk incurred through their firms' trading activity, especially with respect to derivatives trading.
The Commission has undertaken several initiatives to better understand how securities firms manage market and credit risk through the use of statistical models. The Derivatives Policy Group, consisting of the six U.S. firms most active in the OTC derivatives market, is one such initiative. It issued its Framework for Voluntary Oversight in 1995. The Commission has also actively participated in international undertakings, through its membership in the International Organization of Securities Commissions ("IOSCO") and in cooperation with the Basle Committee on Banking Supervision, to gain further experience with the use of statistical models to measure market and credit risk. In 1997, the Commission adopted market risk disclosure rules requiring reporting companies to disclose the policies used to account for derivatives, and certain qualitative and quantitative information about market risk exposures. 350 The Commission also adopted amendments to the net capital rule to permit broker-dealers to employ theoretical option pricing models in determining net capital requirements for listed options and related positions. 351 The Commission is currently considering additional proposals to allow the use of risk-based models to calculate net capital.
As discussed in prior chapters, the Commission's May 1996 release provided guidance on the use of electronic media by broker-dealers, transfer agents, and investment advisors to fulfill their obligations to deliver certain information to customers. 352 By allowing broker-dealers, transfer agents, and investment advisers to agree with their customers on the medium through which information is provided, the release provided these entities with needed flexibility without sacrificing the investor protections provided by the federal securities laws. As previously noted, the release sets out general factors that must be considered when electronic delivery is used, such as whether investors have adequate notice that electronic documents have been delivered, whether investors can access such documents easily, and how evidence to show delivery may be established. The release also cautions regulated entities to take precautions to ensure the integrity, confidentiality, and security of their clients' personal financial information, and to obtain client consent prior to delivering personal financial information electronically.
As markets and market participants become more dependent on technology, the Commission has become increasingly concerned about the security and integrity of the computer systems used by the industry. For example, the October 1987 market break revealed that SROs' automated systems were vulnerable to operational problems during periods of extreme high volume. Inadequate computer capacity caused queues of unprocessed orders to develop that, in turn, resulted in significant delays in execution, while the SROs did not have adequate contingency plans to free-up or create additional file space to accommodate the increase in order traffic. 353 A series of incidents in 1989 revealed that the markets continued to be vulnerable to volume surges and external circumstances. 354
On November 16, 1989, the Commission issued its first Automation Review Policy Statement ("ARP I"), 355 in which it stated its view that the SROs, on a voluntary basis, should establish comprehensive planning and assessment programs to determine systems capacity and vulnerability. The Commission issued its second Automation Review Policy Statement on May 9, 1991 ("ARP II"). 356 In ARP II, the Commission set forth guidance concerning the nature of the independent reviews recommended in ARP I. The Commission also presented the SROs with guidelines for providing the Commission with information regarding automation developments or enhancements and system outages. 357 As the result of Commission and SRO efforts, all SROs currently have contingency and capacity plans, and have built in extra capacity for volatile trading days.
The operational problems that prompted the Commission's ARP Statements are not unique to SROs. Like SROs, broker-dealers have experienced operational problems caused by disasters and market volatility. For example, the explosion at the World Trade Center affected a number of brokerage firms. Several major broker-dealers have suffered from systems outages and service failures. On-line broker-dealers have had difficulty at times handling rapid increases in trading volume. 358 Internet service providers have also experienced systems problems, which could have the potential to disrupt the on-line operations of financial service companies. 359
The Commission uses the guideline set out in ARP I and II, and the expertise the staff of the Division of Market Regulation has developed in administering the automation policy review program, as the basis for evaluating operational problems at market entities other than SROs, and for coordinating industry-wide technology projects. For example, the Commission has taken action to prompt the SROs and major market participants to prepare their computer systems for the Year 2000, and is working closely with industry groups as they develop plans to conduct industry wide testing for Year 2000 problems throughout 1999.
In the past year, a number of issuers have established sites on the World Wide Web that would permit investors to post their willingness to buy or sell the issuer's securities. Generally there is limited trading interest among market professionals for these securities, and issuer sponsored "bulletin boards" provide an inexpensive mechanism for shareholders to adjust their holdings. The Division of Market Regulation staff has provided these issuers with assurances that it will not recommend that the Commission take enforcement action if they operate such bulletin boards without registering with the Commission as a national securities exchange under Section 6 or as a broker-dealer under Section 15 of the Exchange Act. 360 The staff made this determination based on the issuers' representations regarding the manner of operation of such systems. In particular, the staff noted that neither the issuers nor any affiliate will receive, transfer, or hold investor funds or securities, receive any compensation for the use of the system or for creating or maintaining the system, be involved in the purchase of securities or sale negotiations, or give advice regarding the advisability of purchasing securities. Also, the issuers will keep records of quotes entered into the system and make those records available to the Commission and the NASD. The staff also noted that the issuers' securities were registered with the Commission or, if the stock ceased to be registered with the Commission, the issuers would make available on their web sites the financial information required of issuers of registered securities.
The staff has also granted no-action relief from broker-dealer and exchange registration to an Internet-based listing service established by a consortium of universities and other non-profit entities to bring together start-up companies and potential investors. 361 In taking this position, the staff noted that the system and its operators would not provide advice about the merits of particular opportunities or ventures. They would not receive compensation from users other than a nominal, flat fee to cover administrative costs, and such fees would not be made contingent upon the outcome or completion of any securities transactions resulting from a listing on the network. They would not participate in any negotiations between investors and listing companies nor would they directly assist investors or listing companies with the completion of any transaction, handle funds or securities involved in completing a transaction, or hold themselves out as providing any securities related services other than a listing or matching service. Recognizing that many financial service providers may wish to contract with technology companies to provide certain customer services, Commission staff have also issued a no-action letter allowing commercial on-line services such as America Online and Microsoft Network to receive a nominal, flat fee for securities orders sent by on-line broker-dealers without requiring the services to register as broker-dealers. 362
The Commission recently amended its record retention rule, Rule 17a-4, 363 to allow broker-dealers to use electronic storage media, such as CD-ROM and optical disk technology, to maintain their required records. This rule is not limited to electronic communications but includes all required records in whatever form they are originally produced. The rule amendment does not specify the type of storage technology that may be used, but rather provides flexibility by setting forth minimum standards that an electronic storage medium must satisfy to be considered an acceptable method of storage under Rule 17a-4. The Commission release adopting the amendments to Rule 17a-4 also states that the Division staff will not recommend enforcement action to the Commission if broker-dealers, transfer agents, and clearing agencies fulfill their record retention and preservation requirements set forth under certain other Exchange Act rules by using electronic storage media in the manner permitted under Rule 17a-4(f). 364
As amended, Rule 17a-4 provides that any electronic media used to satisfy the rule's requirements must preserve the records exclusively in a non-rewritable, non-erasable format; verify automatically the quality and accuracy of the storage media recording process; serialize the original storage media and time-date the information for the required period of retention; and have the capacity to readily download indexes and records preserved on the media. 365 In addition, any broker-dealer using electronic storage media must have available facilities for immediate, easily readable projection or production of the records; be ready at all times to provide any facsimile enlargement that the Commission may request; store a duplicate copy of the record separate from the original; and organize and index accurately all information maintained on both original and any duplicative storage media. 366 The broker-dealer also must have in place an audit system providing for accountability regarding record inputting, and provide the results of such audits to Commission staff. 367
As methods for electronically storing records continue to evolve, the flexibility provided by these general standards is intended to allow broker-dealers to use the most cost-effective and modern technologies while at the same time providing minimum standards that will allow regulators to perform their duties. For example, Commission staff are currently assessing industry requests to modify the record retention requirements to allow centralized electronic storage, rather than at each branch office, and to permit such records to be retrieved within a reasonable amount of time, rather than "immediately."
In the release adopting the amendments to Rule 17a-4, the Commission also provided guidance to broker-dealers about their obligation to retain e-mail or Internet communications. Although broker-dealers use e-mail and the Internet to communicate important information relating to the broker-dealer's business internally, to customers, and to the general public, they also use such electronic systems for communications unrelated to the business of the broker-dealer. Accordingly, the Commission clarified that for record retention purposes under Rule 17a-4, the content of electronic and Internet communications is determinative, and therefore broker-dealers must retain only those e-mails and Internet communications that relate to the broker-dealer's business as such. 368
Some members of the securities industry have raised concerns regarding their ability to economically index and retrieve stored electronic communications. 369 Currently, Commission staff is working with industry groups to address these concerns and to analyze the costs and burdens associated with the storage and retrieval of electronic information.
Like the Commission, the SROs are adapting their rules and policies to deal with the use of electronic media, such as advertising on the Internet and supervision of electronic communications by registered persons. In 1995, the Commission approved amendments to the NASD Rules of Fair Practice ("Fair Practice Rules") broadening the definitions of "Advertisement" and "Sales Literature" to specifically include electronic media and communications, 370 and revising the approval and filing requirements for advertising materials and sales literature. 371 In addition, the Fair Practice Rules were amended to require supervisory approval of all advertising and sales literature prior to their use or filing with the NASD. 372 SRO rules also require member firms to review all written communications such as correspondence, advertisements, sales literature, and research reports with the public by registered representatives under their supervision. Telephone conversations, however, are not specifically regulated and are less closely monitored. Although it has been argued that e-mail messages are more nearly like telephone calls than written communications, SROs currently regard e-mail as written communications. The industry believes that, in the future, a great deal of business will be done by electronic communication, and has expressed concern about the burden of supervising such correspondence. In response to these concerns, the NYSE and the NASD have filed with the Commission proposals to amend their rules governing supervision of correspondence with the public. 373
While the NYSE and NASD proposals are not identical, they generally propose to replace the blanket supervision requirement with a general requirement that member firms develop written procedures for review of communications with the public designed to provide reasonable supervision of each registered representative. In addition, any firm that does not conduct pre-use review of correspondence (whether electronic or manual) would be required to regularly educate and train employees about the organization's policies and procedures governing review of communications, document such education and training, and conduct surveillance to ensure compliance with the procedures.
Both the NYSE and the NASD filings are currently under review by Commission staff. As part of the review process, the two SROs are working to make their proposals consistent, and to prepare memoranda informing their members about the proposed changes. These memos would discuss the new rules, describe compliance alternatives, and explain changes from prior rules. They also would detail the steps to be taken by a member firm to adequately comply with its supervisory requirements under the rule.
The Commission actively monitors the state of technology in the markets and the effect of technological advances on both the industry and the Commission's regulatory program. In its oversight of the securities markets, the Commission has tried to balance the industry's need to develop more efficient methods of doing business, the desire of market professionals and investors for guidance and regulatory certainty, and the Commission's own mandate to protect investors and maintain fair and efficient markets. Overall, recent advances in technology have brought greater transparency, provided unprecedented opportunities for innovation and competition, facilitated tremendous increases in trading volume, and made possible the development of methods to reduce risk. At the same time, the rapid pace of technology-driven changes to the markets have challenged, and will continue to challenge, the Commission to reevaluate and revise the manner in which it oversees the nations' securities markets. The Commission continues to work with the industry to reduce any tensions caused by technological changes and regulatory obligations.
Vigilant enforcement of the federal securities laws plays a crucial role in fulfilling the Commission's mandate to protect investors and the integrity of the markets. An active and visible enforcement presence promotes compliance with legal requirements, and redresses and deters fraud. Exercising the broad authority it has been granted by Congress, the Commission has developed a flexible and dynamic enforcement program that has effectively addressed rapidly changing market conditions and industry practices over the decades. This chapter will discuss how this program has addressed challenges presented by the growth of the Internet, patterns and trends in Internet fraud, and the Commission's cooperation and coordination with other regulatory authorities.
Recent advances in the use of technology by market participants and others have presented new challenges for the enforcement program, and will undoubtedly continue to do so. While, as in the past, these new challenges may require the adaptation of enforcement policies and practices, the fundamental goals and approach of the Commission's enforcement program can be expected to remain constant despite a changing technological environment.
To date, the developments discussed in this report have not required any significant alterations in the enforcement program's policies and practices. However, the emergence of the Internet as a potential growth vehicle for securities fraud and other potential abuse is of concern to the Commission. The Commission is responding to this challenge with an evolving program of education, surveillance and litigation.
The Internet appears to be at a relatively early stage of its development and the securities law violations that have been attempted through it have not had widespread adverse effects on the markets thus far. Certainly, losses attributable to Internet schemes remain a small fraction of those resulting from abuses attributable to other violations of the securities laws. 374 As the Internet continues to grow, however, the potential for violative conduct, and resulting losses to investors, may grow apace. The Commission, therefore, has moved aggressively to prevent the Internet from becoming a preferred forum for committing securities fraud.
The Commission has long recognized that the prevention of fraud through investor education is frequently more effective than after-the-fact remedies in minimizing investor losses. This is particularly the case with respect to investors who utilize the Internet. The international and potentially anonymous quality of the Internet adds new impediments to obtaining the return of investor funds after they are in the pockets of fraud artists. An Internet address may be a mere electronic blind concealing individuals who are not readily traceable after their fraud comes to light, who are located outside the United States, and whose domestic bank accounts are no more than conduits for the transmission of investor funds to foreign financial institutions.
In its effort to prevent the market hazards created by the new technology from resulting in investor losses, the Commission has established a significant presence on the Internet. The Commission's web site contains, among other things, electronic copies of the periodic reports that public companies are required to file with the Commission, and the Commission's News Digest, which contains summaries of important actions by the agency. The web page maintained by the Commission's Office of Investor Education and Assistance ("OIEA") has links to electronic copies of its investor brochures. In conjunction with the Division of Enforcement, OIEA posts Investor Alerts about patterns of violative conduct such as Prime Bank note and telecommunications frauds. One of these Alerts concerns violative conduct over the Internet, 375 and lists indicia of on-line fraud and steps to follow before making an on-line investment.
The Enforcement page of the Commission's web site is linked to electronic copies of releases describing recent civil injunctive and administrative proceedings, as well as opinions issued by the Commission and its Administrative Law Judges. The Division of Enforcement also, from time to time, posts news items that notify purchasers of particular stocks of the existence of disgorgement funds obtained in enforcement actions that may be available for reimbursement of losses.
In addition to its own web site, the Commission posts information to other cyberspace locations such as Internet newsgroups and the investor forums maintained by commercial on-line services to alert investors to relevant enforcement actions. The first posting of this type was a press release announcing the suspension of trading in stock issued by Omnigene Diagnostics, Inc. 376 The release was posted to an America OnLine forum dedicated to discussions of Omnigene. Subsequently, the Commission has posted notices of trading suspensions in other cases, including those involving the securities of Interactive Multimedia Publishers, Inc., Alliance Industries, Inc., and Green Oasis Environmental, Inc.
The Commission, through the Division of Enforcement, also has placed warnings in newsgroups and securities related areas of commercial on-line services to alert investors to enforcement actions affecting stocks under discussion in those locations. These activities both inform Internet investors of the Commission's concerns with respect to particular securities and demonstrate the Commission's active monitoring of those areas in cyberspace that can be misused for securities law violations.
Although committed to continuing its educational role on the Internet, the Commission realizes that, on the Internet as elsewhere, good information does not always drive out bad before investor harm results. The Commission therefore maintains a program of surveillance intended to enable it to respond proactively to potentially serious frauds. Approximately 70 staff members have been trained in this function and a substantial number of these participate weekly in Internet surveillance activities.
Through its web page, the Commission has created a Complaint Center which the public can use to submit information electronically about potential violations. 377 Users can fill out an on-line complaint form that contains fields for basic information about the alleged violative conduct. In addition, information may be sent to the Division by addressing e-mail through any Internet service provider to firstname.lastname@example.org . The Complaint Center currently receives approximately 100 submissions a day. The Center has been of tremendous assistance to the Commission's surveillance effort, with respect to both abuses occurring on the Internet and more traditional violations. Moreover, the content and quality of the complaints continue to demonstrate the sophistication of users and their willingness to participate in protecting the integrity of Internet communications.
The very nature of the new medium, however, makes monitoring potentially fraudulent promotions a substantial challenge. The volume of investment pitches on the Internet is presently huge and potentially limitless. Software packages are readily available that permit a user without knowledge of programming to construct a web page with a few keystrokes on a home computer. 378 Hence, the volume of Internet solicitations, including the false and misleading, can be expected to increase substantially.
Moreover, the vague quality of many of the solicitations disseminated through Internet e-mail and electronic bulletin boards makes it difficult to separate, without further investigation in each case, the fraudulent promotions from those that are merely unrealistic. It may also be less than obvious which among the many dubious promotions pose a serious threat to investors. It appears that the great majority attract few if any victims. The Commission's enforcement resources are limited and should not be exhausted pursuing myriad scams that will fail with or without our intervention. There have also been many cases -- for example, when it turned out that potentially violative materials were being posted on a web site created by a high school student -- which the staff has been able to resolve on an informal basis simply by explaining that the conduct may be illegal and should be terminated.
In its Internet surveillance program, the Commission staff must comply with all applicable legal requirements concerning privacy and due process. The Commission staff is required, pursuant to the Privacy Act, 379 to identify itself and the purpose of its inquiry when requesting information from the public. Although the staff may browse Internet postings that are open to the public without violating this provision of the Privacy Act, certain sites demand the identity of potential investors before providing the details of a purported investment opportunity. The staff cannot inspect these promotions without identifying the law enforcement purpose of its inquiry. In addition, the Electronic Communications Privacy Act 380 places restrictions on the staff's ability to obtain information from Internet access providers.
The Commission's program of Internet surveillance has met with substantial success. It has resulted in several filed enforcement actions and numerous on-going investigations by the Division of Enforcement. It has also provided a rich source of referrals to state, federal and foreign law enforcement agencies.
An effective deterrent to Internet fraud is a demonstrated willingness to pursue serious violators through prompt and aggressive enforcement actions. The Commission has brought injunctive and administrative proceedings against a number of Internet violators and will likely continue these efforts as Internet use increases. These cases follow from the Commission's surveillance efforts as well as tips from the investing public.
The Commission's authority to enforce the federal securities laws is broad and flexible. Because the basic anti-fraud provisions, Section 10(b) of the Exchange Act 381 and Section 17(a) of the Securities Act, 382 reach virtually any fraud related to transactions in securities, they are not limited to situations involving any particular technology. Provisions requiring the registration of securities 383 and full disclosure of material information to investors, as well as the provisions requiring registration of entities and individuals involved in the securities business, 384 are also broadly drafted. Thus the Commission has the ability to adapt its enforcement program to a rapidly changing technological environment. 385
Unlike many other federal agencies, the Commission has been given broad authority to bring its own civil actions in federal district court or to institute administrative proceedings in which an administrative law judge may impose sanctions. 386 In matters brought in district court, the Commission can obtain injunctive orders that prohibit future violations of the federal securities laws. In emergency situations, the Commission often seeks temporary restraining orders, which can be issued by a district court on an ex parte basis, and preliminary injunctions. The courts also have the power to require the payment of civil penalties in Commission actions, 387 and to require defendants to pay disgorgement of ill-gotten gains. In many cases, disgorgement payments are distributed to defrauded investors. In Commission actions, the courts can also appoint receivers, order defendants to account for illegally obtained funds, and bar individuals from acting as corporate officers or directors. 388
The Securities Enforcement Remedies and Penny Stock Reform Act of 1990 gave the Commission the power to institute administrative proceedings to obtain cease and desist orders against any person violating or causing violations of the federal securities laws, and the disgorgement of ill-gotten gains. 389 This cease and desist authority is in addition to the Commission's long-standing power to bring administrative proceedings against regulated entities, such as securities firms, and their employees, in which it may, among other things, revoke or suspend the licenses of regulated entities and bar or suspend securities professionals. 390
Further, any violation of the federal securities laws can be prosecuted as a criminal offense. 391 The Commission is authorized to refer matters to the Department of Justice for possible criminal action, 392 and does so in appropriate cases.
The Internet has not so much produced new forms of fraud as it has expanded possibilities for well-established methods of separating investors from their money. In turn, Internet securities fraud has created additional challenges to those seeking the return of that money. The violative conduct that the Commission has seen in this area, as in traditional forms of securities fraud, generally falls within two categories. False statements are made either to: (1) sell worthless or overvalued securities to the public; or (2) manipulate the price of securities traded in the secondary market.
Fraudulent offering cases may involve the Internet either as the means by which misrepresentations are disseminated, as discussed below, or as the subject of the misrepresentations. Fraud artists often purport to offer an interest in "hot" new areas that are already the subject of extensive media coverage. Companies that can be promoted as involved in high technology ventures can be an ideal vehicle for such schemes because few members of the public will be able to evaluate the feasibility or likelihood of success of their products. In addition, dishonest promoters can emphasize that the investor is coming in on the "ground floor" of a nascent industry in which future growth may produce much higher than usual returns on capital. In the last two years, a number of Internet related start-up companies have in fact generated wealth for founders and early investors, and can be used as exemplars by promoters of fraudulent ventures.
In one recent case of this type, 393 a task force formed by the Commission, the FBI, the U.S. Marshal's Service and the Florida Attorney General's Office closed down seven offices of a boiler-room operation that solicited investors to purchase shares of a purported Internet service provider. In fact, the issuer was merely a shell company with no assets, and the offering materials contained baseless financial projections. Defendants raised more than $4 million from over 200 investors nationwide.
More common, however, are cases in which the Internet and related methods of communication are used to disseminate fraudulent solicitations about entities not otherwise involved with the Internet. These schemes may be seen as a predictable evolution from the more traditional methods of reaching investors through telephone cold calls and mass mailings. As in the older scams, investors are often promised high rates of return on investments described as risk-free. The touted securities in such schemes often represent interests in non-existent businesses, and the offering proceeds are simply misappropriated by the promoters. For example, the first injunctive action filed by the Commission alleging fraud over the Internet 394 involved individuals who raised more than $3 million by soliciting investors through the Internet to invest in a purported telephone lottery that did not, in fact, exist. In SEC v. Western Executive Group, Inc. , 395 the defendants had used the Internet to sell $3.49 million in investment contracts concerning the sale and leaseback of automated teller machines. Investors were "guaranteed" monthly lease payments representing a 100% return on principal and an annual yield of 17.4%. In operating what was essentially a classic Ponzi scheme, the defendants used new investor funds to meet the monthly lease obligations to existing investors. 396
To emphasize the supposedly risk-free nature of the investments, securities touted in Internet scams are often compared to, or said to be secured by, bank certificates of deposit or similarly safe investments. A case of this type was SEC v. Sellin . 397 In that matter, the Commission alleged that William B. Sellin, a convicted felon and repeat securities law violator, had conducted a fraudulent offering of securities through newsgroups and bulletin board postings on the Internet. Sellin offered promissory notes, with "guaranteed" annual returns ranging from 12% to 22%, that he claimed were secured and collateralized by U.S. government securities. The Commission's complaint alleged that all of these statements were false. 398
The Commission has even seen instances in which purported guarantees were supported by fictitious "Prime Bank" instruments, which themselves have been the subject of a significant number of Commission actions in recent years. In SEC v. Block , 399 for example, the Commission brought an injunctive action against individuals who had employed the Internet to raise approximately $1 million through advertisements that promised investors annual returns of 200% to 420%, purportedly secured against loss by use of "prime bank notes." No such instruments exist in financial markets.
A quality of the Internet that makes it an attractive vehicle for stock fraud, as well as many legitimate forms of communication, is the enormous volume of messages it can accommodate cheaply. Like consumer frauds that rely on mass mailings, where only a small percentage of people solicited are likely to be taken in, the low cost of the solicitation medium may compensate for a low response rate from the targeted population. This factor is illustrated by the widespread promotion of electronic versions of the classic pyramid scheme, in which the participants attempt to make money solely by recruiting new participants in the program. This type of fraud is well-suited for the world of on-line computing, where it is possible to send messages to thousands of people with a few keystrokes. As in other pyramid schemes, of course, the "investment opportunities" collapse under their own weight when no new investors can be found.
The Internet can also provide a method for people with an interest in a security to manipulate its price. 400 Graphically impressive web pages, with links to real information sources, may create the impression that a valueless stock is actually backed by substantial corporate resources. Moreover, on-line messages may persuade readers to buy a particular stock by representing it as destined for rapid growth. Such postings are often made by persons claiming to have inside information about an impending development, or who pick stocks from an "infallible" combination of economic and stock market data. In fact, these promoters, as in traditional boiler-room and other high pressure sales campaigns, may be engaged in "pump and dump" schemes, manipulating upward the price of stocks they own to then sell their positions at an artificially high price. 401
In SEC v. Huttoe , 402 the Commission obtained a temporary restraining order and other emergency relief to stop a market manipulation of the stock of Systems of Excellence, Inc., characterized by extensive hype, using the acronym SEXI, in Internet newsgroups. Charles Huttoe, SEXI's chairman and chief executive officer, secretly distributed millions of shares to family members and their corporations, manipulated the market by issuing false information concerning SEXI and its business, and then sold his own shares into the inflated market. As a result of this scheme, which involved posting more than 10,000 messages about SEXI in cyberspace, the defendants obtained illegal proceeds of more than $10 million. Huttoe also was prosecuted in related criminal proceedings. 403
The Internet is a promising vehicle for frauds of this type because Internet users with a certain level of sophistication can conceal their identities when sending messages or posting material. For example, messages can be sent through third parties who, as a service, will strip off those portions of messages that identify the original source before forwarding the messages to their ultimate destination. These services often have legitimate uses, such as protecting whistle blowers from retaliation. It is clear, however, that the services can also be abused. Anonymous postings can be placed in public areas of the Internet to tout a stock, and anyone seeking to sell or manipulate a stock can easily create the false impression that independent parties are the source of recommendations. This situation arose in SEC v. Octagon , 404 in which one of the defendants touted non-existent bonds by posting notices on three investment-related Internet newsgroups without disclosing his relationship with the purported issuer. It is also theoretically possible to post messages that contain the identifiers of actual corporate officers, thus making it appear that messages represent true inside information about a company or its stock. 405
Related to these forms of manipulative conduct are instances in which the Internet is used to tout stocks by individuals who pose as objective third parties but are, in fact, merely paid promoters. Publishers who provide investment advice to the public on a regular basis are not generally required to register with the Commission under the Investment Advisers Act. However, the Commission can take appropriate action when such publications are used fraudulently or otherwise in violation of the federal securities laws. 406
For example, in SEC v. Chelekis 407 the Commission sued the publishers of certain Internet "Hot Stocks" newsletters who illegally failed to disclose their receipt of at least $1.1 million from more than 150 issuers, and 275,000 shares of stock from ten issuers, as compensation for making "buy" recommendations in their newsletter. 408 In the Systems of Excellence litigation, the Commission alleged that Theodore R. Melcher, Jr., the publisher of an Internet newsletter, the Goldstar Whisper Stock Report, received bribes from SOE and other issuers in exchange for recommending the securities of those issuers to Goldstar subscribers. The Commission also alleged that Goldstar and associated persons failed to disclose that they had sold certain securities while recommending that Goldstar subscribers buy those same securities. Melcher, like Huttoe, was convicted in related criminal proceedings. 409
The potential breadth of illicit activities on the Internet requires extensive coordination with other agencies. The Commission has long recognized the value of such coordination, which not only prevents duplication of effort but also ensures that violations are remedied by the agency that can tailor the most effective response in light of the circumstances of a case. Securities frauds over the Internet may, for example, also constitute violations of statutes administered by the Federal Trade Commission, the Federal Communications Commission or by a variety of state regulators.
In the past, the Commission has been highly successful in coordinating law enforcement efforts, and continues to do so in the Internet area. In connection with Internet investigations, the Division of Enforcement has formally and informally coordinated with the Department of Justice and the FBI, as well as the FTC and FCC and a range of other civil and criminal law enforcement authorities. For example, in December 1996, the Commission joined three other federal agencies and 70 state and local law enforcement officials from 24 states on "Surf Day," which resulted in the identification of a large number of potential scams operating through the Internet.
The Division also works closely with the self-regulatory organizations, such as the National Association of Securities Dealers and the New York Stock Exchange, as well as state regulatory authorities, either directly or through the North American Securities Administrators Association.
A key strength of the Internet is that it permits seamless communication without regard to national boundaries. Web sites posted in one country can easily be hyperlinked to sites originating in others, and search engines routinely collect information internationally. An implication of this global interconnection, however, is that a person seeking to defraud U.S. investors need not actually be located in the United States.
The Commission may bring fraud actions against securities laws violators in the United States regardless of their state of residence. The Commission also may bring fraud actions against securities laws violators who are outside the United States. Courts routinely have found subject matter jurisdiction where there is either conduct or effects in the United States relating to a violation of the U.S. securities laws. 410 Courts also routinely have found personal jurisdiction over non-resident defendants in securities fraud cases. 411 The exercise of personal jurisdiction is consistent with due process when the defendant has purposefully established "minimum contacts" with the forum and the exercise of personal jurisdiction will not offend "traditional notions of fair play and substantial justice."
As a result, the Commission addresses international jurisdiction in fraud cases on the Internet in the same way as in other fraud cases where the violations originate outside the U.S. The Commission has already been successful in this area. 412 In addition, the Commission has been successful in having courts freeze assets obtained through fraud where there is a risk that the assets may be removed.
The Commission recognizes that its practical ability to protect American investors from international fraud and other violations that occur over the Internet is greatly enhanced by fostering cooperative relationships with foreign authorities. This requires building upon a framework of international agreements and relationships already in place.
The Commission's Office of International Affairs has helped build a strong international program, and a solid framework is in place to respond to technology-related issues. The Commission's international program consists of cooperating with foreign authorities in enforcement and regulatory matters; initiating and contributing to projects undertaken in international organizations; and coordinating and providing training and technical assistance.
To promote cooperation in the enforcement context, the Commission has in place formal and informal information sharing arrangements with foreign authorities to obtain assistance and exchange information in enforcement matters. 413 In addition, the Commission develops international regulatory initiatives to better protect U.S. investors and markets. 414 This framework allows the Commission to consider both enforcement and regulatory aspects to technology-related issues and respond to them.
The Commission regularly receives information about potential fraud or other misconduct carried out on the Internet that may have a foreign origin. This information is carefully reviewed and either referred to the relevant foreign securities authority, or in appropriate cases, to the Commission's Division of Enforcement. The Commission has brought suit in foreign courts to enforce judgments obtained in U.S. courts and to protect assets held overseas.
In the regulatory area, the Commission recognizes that regulators around the world may be approaching issues related to technology and the Internet differently. Because regulatory differences can have an adverse effect on the international marketplace, the Commission is taking steps to ensure that securities regulators around the world develop compatible approaches to the regulation of Internet-related activities.
In both the enforcement and regulatory areas, the Commission is working through international organizations such as the International Organization of Securities Commissions (IOSCO) 415 and the Council of Securities Regulators of the Americas ("COSRA") 416 to promote coordination, cooperation and exchange of information on technology related issues. The Commission is very active in both of these organizations. IOSCO and COSRA are good venues for discussing all issues common to securities regulators, including issues related to technology and the Internet.
IOSCO is giving issues related to the Internet particular emphasis. Most recently, IOSCO formed a high level Task Force to address Internet-related issues, including enforcement and exchange of information, disclosure and dissemination of information in the primary markets, regulation of the secondary markets, and regulation of investment companies and advisory services. The Commission plays a leading role in the Task Force.
IOSCO recently published a paper entitled "Report on Enforcement Issues Raised by the Increasing Use of Electronic Networks in the Securities and Futures Field." 417 The paper discusses securities enforcement issues raised by use of the Internet, and makes recommendations as to mechanisms that regulators might employ to counter fraud jointly and to exchange information about fraud on the Internet.
IOSCO has also undertaken an initiative to encourage improved surveillance of activities on the Internet, and the sharing of information regarding surveillance techniques. Recognizing a need on the part of many foreign regulators to receive training and exchange information on conducting surveillance on the Internet, the Commission, in conjunction with the CFTC, held a training session for representatives from 15 IOSCO members around the world to exchange information regarding electronic surveillance techniques. The participants shared information on technologically advanced methods to monitor trading and other market activity on the Internet. 418
The Commission's technical assistance program is another structure already in place to respond to issues related to technology and the Internet. For example, the Commission's International Training Institutes 419 include sections devoted specifically to Internet related issues. The Commission also responds to requests for technical assistance from foreign securities regulators in the area of emerging technologies.
The Commission also has taken the lead in encouraging foreign securities authorities to use the Internet to facilitate the development of their markets and specifically to educate investors on a wide range of topics. Partly as a result, IOSCO has established a web site, which makes information available about the organization and its work, 420 and securities authorities around the world have begun to offer on the Internet a variety of educational and news material for investors and firms, as well as copies of rules and regulations governing securities regulation.
The Commission's enforcement program plays a vital role in protecting investors and the integrity of the markets. The Commission has moved aggressively to prevent and redress violative conduct made possible by technological advances, such as the Internet. As access to the Internet continues to grow, the potential for violative conduct may increase as well. The Commission's flexible program and broad authority will enable it to meet the challenges posed by the changing technological environment.
Angel Capital Electronic Network
The staff stated that it would not recommend enforcement action to the Commission if several universities and non-profit entities operated a service on a web site (the "Network"), without registering as broker-dealers, without the Network registering as a broker-dealer or exchange, and without the Network and the Network operators registering as investment advisers. The service would allow accredited investors to access a password-controlled listing of small corporate offerings and to download offering materials.
The staff confirmed that identification of Baltimore Gas and Electric's ("BG&E") web site in a prospectus and a statement that BG&E filings are available on its web site will not, by itself, incorporate by reference information from the web site into the registration statement that is not otherwise incorporated.
The staff stated that it would not recommend enforcement action to the Commission if the bank utilized software designed to facilitate "cloning," the management and operation of legally distinct mirror portfolios by a single investment adviser.
The staff gave interpretive advice stating that the Securities Act definition of prospectus would include an electronic prospectus and that a prospectus transmitted electronically would be deemed to be sent prior to the security if the issuer met certain stated conditions. This letter was superseded by the 1995 Interpretive Release.
The staff stated that it would not recommend enforcement action to the Commission if Charles Schwab & Co., Inc., a registered broker-dealer, paid certain Internet on-line services a fee for routing orders sent by the broker-dealer's customers, without those on-line services registering as broker-dealers.
The staff agreed that customer purchase or sale orders placed directly with Schwab or its sub-designee may be deemed to have been received by the relevant fund for purposes of Rule 22c-1 under the Investment Company Act, 17 CFR 270.22c-1, at the time that Schwab or its sub-designee accepts the order.
The staff indicated that under certain stated conditions, it would not recommend enforcement action to the Commission if Chicago Board Brokerage
The staff stated that it would not recommend enforcement action to the Commission if Flamemaster, without registering as a broker-dealer, an exchange or an investment adviser, operated an Internet bulletin board on which interested buyers and sellers could post indications of interest in Flamemaster's securities.
The staff confirmed that Instinet Real-Time Trading Service, which combines dynamically-updated equity securities market information with customer order entry, negotiation and execution capabilities, is an "electronic communications network" for purposes of the Commission's Order Execution Rules. The staff also stated that it would not recommend enforcement action to the Commission against over-the-counter market maker participants in the system if those participants enter orders into the system without modifying their public quotations in compliance with the Order Execution Rules.
The staff stated that it would not recommend enforcement action to the Commission against the sponsor and the system manager of a screen-based brokerage system for the secondary trading of commercial real estate equity and debt securities owned by U.S. pension funds and other institutional investors, without registration of the system as an exchange or registration of the system manager as a clearing agency.
The staff indicated that the use of an Internet-based system to pre-qualify accredited and sophisticated investors to whom Regulation D offering materials for offerings posted after the pre-qualification would later be made accessible would not constitute general solicitation or general advertising. The staff also stated that indications of interest to be accepted by an electronic coupon meet the requirements applicable to paper cards or coupons.
The staff confirmed that Island, which is an automated limit order book with automatic matching capabilities, is an "electronic communications network" for purposes of the Commission's Order Execution Rules. The staff also stated that it would not recommend enforcement action to the Commission against over-the-counter market maker participants in the Island system if those participants enter orders into Island without modifying their public quotations in compliance with the Order Execution Rules.
The staff confirmed that identification of ITT's web site in a prospectus and a statement that ITT's filings are available on its web site will not, by itself, incorporate by reference information from the web site into the registration statement that is not otherwise incorporated.
The staff stated that it would not recommend enforcement action to the Commission against Lamp if certain information about unregistered investment companies were available on Lamp's web site. In addition, the staff confirmed that an investment adviser to a private fund listed on Lamp's web site would not be "holding itself out generally to the public" as an investment adviser. The staff's no-action position relied in part on the presence of password protection for the web site and procedures to limit access to the web site to a select group of accredited investors.
The staff stated that it would not recommend enforcement action to the Commission with respect to a registered investment adviser that made portfolio information about its mutual funds available on the Internet.
The staff stated that, subject to certain conditions, it would not recommend enforcement action to the Commission if Net Roadshow, Inc. transmitted delayed roadshow presentations over the Internet.
The staff stated that it would not recommend enforcement action to the Commission if Niphix were to operate a proprietary electronic broker-dealer trading system without registering as an exchange, a clearing agency or a securities information processor. Securities traded on the system would be exempt securities of small business issuers, who would be required to maintain an information database screen including all disclosures required for purposes of registration for viewing by trading participants on the system.
The staff stated that it would not recommend enforcement action to the Commission if the Oppenheimer investment advisers and investment companies were to maintain and preserve required records on optical disk or comparable imaging technology that may be developed in the future.
The staff stated that it would not recommend enforcement action to the Commission if PerfectData operated an Internet bulletin board on which interested buyers and sellers could post indications of interest in PerfectData's securities, without PerfectData registering as a broker-dealer, an exchange or an investment adviser.
The staff stated, subject to certain conditions, that it would not recommend enforcement action to the Commission if Private Financial Network ("PFN"), a subsidiary of a joint venture between NBC and Microsoft, transmitted live or delayed roadshow presentations by satellite, telephone and cable to PFN subscribers' computer or television monitors.
The staff indicated that it would not recommend enforcement action to the Commission if Real Goods, without registering as a broker-dealer, an exchange or an investment adviser, operated an Internet bulletin board on which interested buyers and sellers could post indications of interest in Real Goods' securities. The staff required, among other things, that Real Goods have no involvement in any transactions other than the posting of interested buyers, sellers and quotes.
The staff suggested certain modifications to an electronic bulletin board on the Internet to enable the bulletin board to comply with the federal securities laws and reduce the possibility of market manipulation.
The staff confirmed that TONTO is an "electronic communications network" for purposes of the Commission's Order Execution Rules. The staff also stated that it would not recommend enforcement action to the Commission against over-the-counter market maker participants in the TONTO system if those participants enter orders into TONTO without modifying their public quotations in compliance with the Order Execution Rules.
(Jan. 21, 1997)
The staff confirmed that Bloomberg's Tradebook System, which provides broker-dealers and institutional clients with automatic execution, clearance and settlement of trades in certain equity securities by a worldwide, proprietary electronic network, is an "electronic communications network" for purposes of the Commission's Order Execution Rules. The staff also stated that it would not recommend enforcement action to the Commission against over-the-counter market maker participants in the system if those participants enter orders into the system without modifying their public quotations in compliance with the Order Execution Rules.
Gene Block of Durham, North Carolina, operating through Block Consulting Services, and Robert T. Riley, Jr., of St. Louis, Missouri, operating through the Roberts Group, used advertisements on the Internet to raise over $1 million through the sale of securities offered through an investment program run by defendant Renate Haag. Investors were promised, in some cases, returns of 200% to 420% annually, and were told that their investments would be guaranteed against loss by "Prime Bank Guarantees." In fact, Prime Bank Guarantees do not exist. Block and Riley consented to the entry of injunctions; the action is pending as to Renate Haag.
The Commission alleged that George Chelekis, a publisher who distributes various investment newsletters, known as the "Hot Stocks" publications, over the Internet and in print format, made materially false and misleading statements about six publicly traded companies. The complaint further alleged that Chelekis failed to disclose in the Hot Stocks publications that he, and entities that he controlled, received at least $1.1 million from more than 150 issuers and 275,000 shares of stock from ten issuers, as payment for recommending securities. Without admitting or denying the allegations in the complaint, the defendants consented to the entry of injunctions and orders requiring that they pay a total of $162,727, representing $75,050 in disgorgement, $12,627 in prejudgment interest and a $75,050 civil penalty.
In the spring of 1995, Scott Frye posted a notice over the Internet soliciting investors by promising "riskless profits and aboveaverage returns" from investments in ICP and the Jupiter Agro Development Project, two Costa Rican enterprises that produced coconut chips. According to the Commission's complaint, Frye misled potential investors by telling them a bank would guarantee their principal and a fifteen percent return in one year, and that one of the companies was a major distributor for A&P Supermarkets. Without admitting or denying the Commission's allegations, Frye consented to the entry of an injunction.
The Commission obtained a temporary restraining order and other emergency relief to stop a market manipulation of stock issued by Systems of Excellence, Inc. (SOE), a scheme characterized by extensive hype in newsgroups. Charles Huttoe, SOE's chairman and chief executive officer, secretly distributed millions of SOE shares to family members and corporations, manipulated the market by issuing false information concerning SOE and its business, and then sold his own shares into the inflated market. As a result of this scheme, the defendants allegedly obtained illegal proceeds of more than $10 million. During the manipulation, more than 10,000 messages about SOE were posted in message areas on the Internet.
In addition, the Commission alleged that SGA Goldstar Research Inc., the publisher of an investment newsletter with wide dissemination over the Internet received bribes from certain other defendants in the case, including SOE. In exchange for the bribes, Goldstar recommended SOE to its subscribers in the SGA Goldstar Whisper Stock Report, which was disseminated by means including the Internet. The Commission alleged that Goldstar and related defendants engaged in a systematic practice of publishing recommendations for numerous issuers without disclosing either their compensation or whether they were selling shares in the companies while recommending that the securities be purchased by their subscribers.
On January 31, 1997, Huttoe was sentenced pursuant to a plea agreement to a federal prison term of 46 months followed by two years of supervised release and a $10,000 fine for one count of securities fraud and one count of money laundering for his role in the scheme. On September 12, 1997, Theodore Melcher, the owner of Goldstar, was sentenced to a federal prison term of 12 months, followed by two years of supervised release and a $20,000 fine. The Commission's investigation in this matter is continuing.
In June 1996, the SEC sued Octagon Technology Group, Inc., a Schaumburg, Illinois, computer software company and two of its former officers for their roles in creating an elaborate sham offering of offshore debt securities on the web. The web site, established for the Agency for Interamerican Finance ("AIF"), a Panamanian shell subsidiary of Octagon, advertised AIF "Interamerican hard currency bonds" for sale to investors. The Commission alleged that this offering was essentially a fraud because no bonds ever existed, and AIF had no business operations or assets. AIF's web pages, however, promised prospective investors a riskfree investment with guaranteed returns of 11.75% annually and portrayed AIF as a successful provider of investment capital to Latin American businesses. Without admitting or denying the Commission's allegations, Octagon and its officers consented to the entry of injunctions, and one officer was ordered to pay a civil penalty of $5000.
In August 1995, the SEC filed a complaint against Daniel Odulo who had solicited investors over several Internet newsgroups, including "misc.invest" and "alt.make.money.fast." Odulo offered bonds purportedly for a company called Golden Waters which he claimed would yield a "whopping 20% rate of return" for a very low risk. Odulo also falsely represented that investors would be insured, and used endorsements from fictitious investment advisers. According to the Commission's complaint, Odulo failed to disclose that Golden Waters was not an on-going concern, but a proposed new venture involving the acquisition and raising of eels. Odulo also failed to disclose that he had no expertise in the culturing of eels. Without admitting or denying the Commission's allegations, Odulo consented to the entry of an injunction.
The Commission's complaint in this action alleged that John C. Hicks and a partner raised more than $3 million by selling securities to approximately 20,000 investors, contacted both on the Internet and over the telephone. Investors were told that they would reap astronomical profits from a worldwide telephone lottery and were encouraged to recruit other investors through the Internet. The complaint alleged that the sales pitch failed to disclose the legal and regulatory obstacles to starting a lottery. Without admitting or denying the allegations, Hicks consented to the entry of an injunction. Default judgments were entered against Pleasure Time, Inc., and other defendants, who were ordered to disgorge a total of $663,831, plus prejudgment interest of $46,567.
William B. Sellin, a convicted felon and repeat securities law violator, conducted a fraudulent offering of securities through newsgroup and bulletin board postings on the Internet, and through advertisements placed on CompuServe. Sellin solicited investments through at least fortythree advertisements in at least twenty-one Internet newsgroups. Acting through defendants Zaitech Holdings, Inc. and Baccaratt Holdings, Inc., Sellin offered promissory notes that he claimed were secured and collateralized by U.S. government securities and other assets. He also represented that he could deliver "guaranteed" annual returns ranging from twelve percent to twenty-two percent and announced that an investor could earn "$150,000 annually, tax free." The Commission alleged that these representations were false and misleading because (i) the investment, in fact, was not secured or collateralized by U.S. government securities; (ii) Sellin failed to disclose his long record of regulatory sanctions and criminal convictions, including a Florida felony conviction for grand larceny; and (iii) Sellin failed to disclose the material risks associated with the investment. Without admitting or denying the Commission's allegations, the defendants consented to the entry of injunctions.
In July 1995, Chicagobased Donald Spencer began soliciting investors over the Internet for his company, IVT Systems, Inc. Spencer told potential investors that the firm was building an ethanol plant in the Dominican Republic, and promised potential returns of fifty percent or more even though "there was no reasonable basis for this prediction," according to the Commission's complaint. Spencer and IVT raised at least $113,500 from twelve investors. The Commission alleged that Spencer's literature contained misrepresentations about purported contracts with wellknown companies and omitted other important information. Without admitting or denying the Commission's allegations, Spencer and IVT consented to the entry of injunctions.
The Commission filed this action to halt an alleged Ponzi scheme involving investment contracts for the sale and leaseback of automated teller machines. The defendants solicited investments in the ATM program over the Internet and through private investment seminars, mass mailings, and cold calling. Investors were guaranteed monthly lease payments for five years, representing a 100% return of the investors' principal and an annual yield of 17.4%. The defendants, who raised over $3.49 million from at least 132 investors nationwide, used new investor funds to meet the monthly lease obligations to existing investors. The Commission has obtained a preliminary injunction and other emergency relief in this case.
On September 26, 1996, the Commission filed a complaint against Wye Resources, Inc., and Rehan Malik alleging that they engaged in a fraudulent promotional campaign targeted towards U.S. investors during 1993 and early 1994, and improperly distributed Wye stock to those investors. Wye, a Canadian corporation headquartered in Toronto, Ontario, claimed to own interests in various gold and diamond mining properties. Malik, a resident of Labrador City, Newfoundland, served as Wye's president from June 24, 1993 through March 25, 1994. The Commission's complaint alleged the distribution of approximately 5.3 million shares of Wye stock that were not properly issued under Canadian law nor properly registered with the Commission; Wye directly distributed approximately 2.5 million of these shares to U.S. investors. The complaint alleged that Wye and Malik specifically targeted U.S. investors by advertising in U.S. publications and posting Internet messages through the New Orleansbased "Emerging Growth Stock BBS." The Commission also alleged that certain of these advertisements and messages were false and misleading because they misrepresented, among other things, the status of Wye's on-going exploitation of certain Zairian mining properties. Without admitting or denying the Commission's allegations, Malik consented to the entry of an injunction and an order requiring him to pay a civil penalty of $25,000.
The Commission instituted related administrative proceedings against two U.S. residents, Murray Aaron Huberfeld and Broad Capital Associates, Inc., in connection with the unregistered distribution of Wye securities. Without admitting or denying the Commission's allegations, the respondents consented to the issuance of an order requiring them to disgorge a total of $426,790.05 plus prejudgment interest.
Footnotes1 Pub. L. No. 104-290, Sec. 510(a), 110 Stat. 3416 (1996).
2 Section 510(a)(1)(A) provides that "[t]he Commission shall conduct a study of--
(i) the impact of technological advances and the use of on-line information systems on the securities markets, including steps the Commission has taken to facilitate the electronic delivery of prospectuses to institutional and other investors;
(ii) how such technologies have changed the way in which the securities markets operate; and
(iii) any steps taken by the Commission to address such changes."
Section 510(a)(1)(B) further provides that "[I]n conducting the study under subparagraph (A), the Commission shall consider how the Commission has adapted its enforcement policies and practices in response to technological developments with regard to--
(i) disclosure, prospectus delivery, and other customer protection regulations;
(ii) intermediaries and exchanges in the domestic and international financial services industry;
(iii) reporting by issuers, including communications with holders of securities;
(iv) the relationship of the Commission with other national regulatory authorities and organizations to improve coordination and cooperation; and
(v) the relationship of the Commission with State regulatory authorities and organizations to improve coordination and cooperation."
3 These developments represent a significant advance since even the most recent examination of the use of information technology in the securities markets. See U.S. Congress, Office of Technology Assessment, Electronic Bulls and Bears: U.S. Securities Markets and Information Technology , OTA-CIT-469 (1990).
4 The implications of technological advances in general, and of the Internet in particular, have been widely recognized. The Administration's Framework for Global Electronic Commerce predicts that advances in what it terms the "Global Information Infrastructure" will soon affect almost every aspect of daily life. A Framework for Global Electronic Commerce <http://www.whitehouse.gov/WH/New/Commerce/index.html>. See also Reno v. American Civil Liberties Union , 117 S.Ct. 2329 (1997).
5 This report assumes familiarity with the basic features of computers and the Internet. Definitions of common terms may be found in Appendix D.
6 This chapter addresses the general corporate regulatory scheme, but does not discuss the regulatory structure and issues related to investment companies, which are addressed in Chapter II.
7 Securities Act Concepts and Their Effects on Capital Formation, Securities Act Release No. 7314 (July 25, 1996) (the "Securities Act Concept Release").
8 Within this framework, the Commission has crafted rules that simplify the registration process for certain classes of issuers, such as large, widely-followed issuers.
9 A registration statement primarily consists of the "prospectus," which is the document by which an offer is made, and supplementary information.
10 After filing with the Commission, a registration statement is immediately available to the public through the EDGAR database or in the Commission's Public Reference Room for those issuers who are not required to file on EDGAR.
11 If the registration statement is not examined by the Commission staff or upon the completion of an examination, the Commission staff will ordinarily "declare" the registration statement "effective" upon request of the company and the underwriter.
12 Rule 504 under Regulation D, 17 CFR 230.504, permits issuers to conduct offerings up to $1 million within a 12 month period. Under Rule 504, there are no limits on the methods of solicitation. Generally, any securities sold are not restricted for resale.
13 17 CFR 230.251 - 230.263.
14 17 CFR 240.14a-3. Certain issuers, such as foreign private issuers or section 15(d) issuers, are not subject to these requirements.
15 17 CFR 240.14a-3(b).
16 17 CFR 240.14a-8. This rule is the subject of another Congressional report recently submitted as required under the National Securities Markets Improvement Act of 1996. Report on Shareholder Proposals (Sept. 18, 1997).
17 In 1992, the Commission reformed its shareholder communication rules, the first major proxy rule reform in nearly 40 years. The proxy rules now permit shareholders to more easily communicate with each other.
18 Use of Electronic Media for Delivery Purposes, Securities Act Release No. 7233, Exchange Act Release No. 36345 (Oct. 6, 1995). A later release relates to the use of electronic media by broker-dealers and investment advisers. Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for Delivery of Information; Additional Examples Under the Securities Act of 1933, Securities Exchange Act of 1934, and Investment Company Act of 1940, Securities Act Release No. 7288, Exchange Act Release No. 37182 (May 9, 1996).
19 In addition, technical rule changes were adopted to facilitate the use of this framework. Id.
20 The May 1996 Release also contains seven examples that apply to public companies. May 1996 Release, supra note 18.
21 In one letter, the Division of Corporation Finance staff provided interpretive relief regarding the general solicitation restrictions to a broker-dealer desiring to assist issuers in conducting private offerings on-line. IPONet, SEC No-Action Letter (publicly available July 26, 1996). In another letter, the staff of the Divisions of Corporation Finance and Investment Management provided additional guidance concerning on-line private offerings of hedge fund securities. Lamp Technologies, Inc., SEC No-Action Letter (publicly available May 29, 1997).
22 See Angel Capital Electronic Network, SEC No-Action Letter (publicly available Oct. 25, 1996), in which general solicitation concerns were not present.
23 In April 1997, the billionth page of corporate information was posted. SEC Web site Transmits Billionth Page of Data to U.S. Investors, Press, and Public; Site Informs Investors, Promotes Efficient Markets, and Enhances SEC Oversight <http://www.sec.gov/news/press/97-35.txt>.
24 Examples 1 through 14 relate to the use of web site prospectuses. October 1995 Release, supra note 18.
25 Howard M. Friedman, Securities Regulation in Cyberspace 3-23 (1997).
26 Salomon Brothers, Inc. posted information relating to Berkshire Hathaway Inc.'s Class B shares offering. Berkshire Hathaway placed tombstone advertisements in newspapers that included the web site's address. Wall St. J., Apr. 22, 1996, at C9. Since the prospectus was posted for informational purposes only, Berkshire Hathaway and Salomon Brothers did not deliver prospectuses, take orders or provide confirmations on-line.
27 In its initial public offering, as a leading Internet search engine provider, Yahoo!, Inc. believed its prospectus' on-line availability was culturally important. D. M. Osborne, The Netty Professor , Am. Law. Tech. Mag., Spring 1997, at 57.
28 While the Commission does not require that a prospectus be the only information on a web site, these issuers and their underwriters voluntarily created a new web site for the prospectus.
29 From its "Direct Access Notes" web site, ABN-AMRO North America Inc., Chicago Corporation has offered General Motors Acceptance Corporation debt securities that are designed for individual investors. Although investors can download a prospectus, participating broker-dealers are delivering paper prospectuses to meet their delivery obligations. Each week, a table is posted that discloses updated terms of the debt. Also posted is educational information and a computer application to assist investors in analyzing debt investments. See Direct Access Notes <http://www.directnotes.com>.
30 Great Plains Software, Inc.'s initial public offering. "Streaming" differs from downloading in that a viewer can hear the file even before it is completely downloaded and that the "streamed" information can not be printed and retained.
31 Lorrie Grant, Small Firms Take Direct Route to Stock Offerings , USA Today, Apr. 29, 1997, at 4B; Mark Kollar, Do-It-Yourself Public Offerings , Inv. Dealers' Dig., Mar. 24, 1997, at 14; Wesley R. Iversen, IPOs on the Web , Fin. Serv. Online , Jan./Feb. 1997, at 22; Stephanie Gruner, When Mom & Pop Go Public , Inc., Dec. 1996, at 66. The Virtual Wall Street Reference Library has a table of DPOs compiled by the SCOR Report that was published in Inc. Magazine in December 1996. See <http://www.virtualwallstreet.com/library/table.shtml>.
32 Eric J. Savitz, Turned On, Tuned Out , Barron's, Sept. 1, 1997.
33 Issuers offering securities exempt from registration may or may not have delivery obligations depending on the exemption claimed. For example, issuers conducting an offering relying on Rule 504 under Regulation D do not have disclosure or delivery obligations under the federal securities laws. State securities laws, however, may impose disclosure and delivery obligations.
34 Regulation A offerings may not exceed $5 million and are exempt from registration with the Commission. Regulation A offerings, however, must still be filed and "qualified" by the Commission.
35 Dan W. Schneider, Thomas J. Cunningham and Kristin M. Davis, Direct Stock Plans on the Web: The Future of Online Investing? , Off-Line, 1997, at 1. On-line direct stock purchase plan directories also appear to be fueling direct stock purchase plan growth. Before on-line directories, an investor had to determine which public companies offered direct stock purchase plans and then call each company individually to learn the details of and order its plan.
36 Generally, self-service refers to systems that allow people to access information without having to go through a third party. Sue Burzawa, "Help yourself!" Employers Tell Workers with Benefits and HR Self-Service Applications , Employee Benefit Plan Rev., June 1997, at 14-18.
37 Maureen M. Phillips, 401k Telephone Service Offers Educational Tool , Argus Business Pension Mgmt., Dec. 1995, at 44.
38 Graham Fysh, Intranet': Fast Route to Benefits; Firms Consider In-House Version of the Internet to Offer Up-to-Date Data on Programs Such as 401(k) , News Trib., July 31, 1997, at B6.
39 Large companies such as Boeing Co. are paving the way with respect to intranet human resources. Companies Look to Web For Internal Answers: Boeing Planning to Enable Web Access to Human Resources , Electronic Comm. News, Mar. 10, 1997, vol. 2, no. 10.
40 Ameritrade Holding Company's initial public offering ("Ameritrade"). Before Ameritrade, in 1996, K-Mart Corp. delivered a CD-ROM private placement offering circular for a credit facility. The offering circular has an interactive video interview with K-Mart's Chairman and CEO, a video tour of a store, clickable questions answered by senior management, spreadsheets to download and manipulate data, and a search engine to perform key-word searches.
41 For example, in July 1997, Sulzer Medica, Ltd. delivered alternative versions of its prospectus.
42 This data is contained on a disk attached to a paper prospectus supplement relating to a "takedown" from a shelf registration.
43 There are commercial services that provide proprietary electronic access to monthly updates of tabular data similar to that delivered in the initial public offering. In many cases, these monthly updates include more information than that provided in Commission filings. In addition, most of the major asset-backed securities trustees post monthly data, primarily consisting of the information obtained by the servicer of the assets, regarding the securities in their trusts on their web sites.
44 In mid-1996, Primary Care Centers of America conducted the first on-line roadshow on Bb-Net, Inc. Investor Relations' web site. Since Primary Care Centers was engaged in an exempt offering under Rule 504, the roadshow was subject only to applicable state law restrictions. This on-line roadshow used video, slides, and audio narration, including interviews with the company's founder, a slide show of the company headquarters and an on-line offering circular. WebFinance, First Internet Roadshow' Launched by Small Company <http://www.webfinance.net/brokerage>.
45 In March 1997, on receiving no-action relief from the Commission staff, the Private Financial Network, a subsidiary of MSNBC Interactive LLC, announced plans to disseminate roadshows to its subscribers under certain conditions. The Private Financial Network disseminates roadshows over satellites, telephone circuits and fiber optic cables to its subscribers. Preliminary prospectuses must be provided to persons who will view the roadshows. See generally Private Financial Network, SEC No-Action Letter (publicly available Mar. 12, 1997).
In September 1997, Net Roadshow received no-action relief from the Commission staff to establish a web site to disseminate roadshows. See Net Roadshow, Inc., SEC No-Action Letter (publicly available Sept. 7, 1997). Qualified investors will be able to select a roadshow from an index. The index will be organized by issuer name, underwriter name, and industry. A qualified investor desiring to view a particular roadshow will be required to contact the appropriate underwriter to obtain the password or access code to access the roadshow. The preliminary prospectus for any offering for which there is a roadshow available will also be available on the web site. SEC Gives Nod to Roadshows' Over the Internet , Wall St. J., Sept. 9, 1997, at B4.
46 In some cases sales literature is provided to the Commission staff, but is not filed with the Commission. For corporate issuers, it is most commonly used in continuous offerings, such as real estate limited partnership and other direct participation program offerings. See Item 19-D of Industry Guide 5 and Rule 418 of Regulation C.
47 October 1995 Release, supra note 18, Example Nos. 14, 15 and 17.
48 See supra note 21 regarding the IPONet and Lamp Technologies, Inc. no-action letters.
49 Rivel Research Group, Utilizing Technology in the Practice of Investor Relations , Nat'l Inv. Rel. Inst. Surveys, Aug. 1996. Hoover's On-line maintains hyperlinks to over 5,000 corporate web sites. See Hoover's On-line <http://www.hoovers.com>.
50 October 1995 Release, supra note 18, at nn.11 & 20.
51 Gloria Santona, More Corporations Using Net to Reach Investors, Nat'l L. J., July 14, 1997. Although not as common as periodic reports, companies frequently post transfer agent information, stock price history, ratings information or expected earnings release dates. "Frequently asked questions" (also known as "FAQs") are in a question and answer format that is often used on web sites to assist investors. Rivel Research Group, Utilizing Technology in the Practice of Investor Relations , Nat'l Inv. Rel. Inst. Surveys, Aug. 1996.
52 Rivel Research Group, Utilizing Technology in the Practice of Investor Relations , Nat'l Inv. Rel. Inst. Surveys, Aug. 1996, at 21.
53 Most postings are created in either HTML, thereby permitting hyperlinks between the document sections, or PDF, allowing the use of search tools.
54 Timothy J. Louwers, William R. Pasewark and Eric W. Typpo, The Internet: Changing the Way Corporations Tell Their Story , CPA J., Nov. 1996, at 24.
55 Microsoft Corp.'s 1996 web site annual report, <http://www.microsoft.com>, provides an Excel spreadsheet that allows viewers to analyze future Microsoft financial results themselves. 3COM Corp.'s and International Business Machines Corp.'s 1996 web site annual reports have similar analytical abilities. See 3COM <http://www.3com.com>; IBM Corp. <http://www.ibm.com>.
56 Adobe Systems, Inc., RR Donnelley & Sons Co., Oklahoma Gas and Electric Co. and Oracle Corp. were among the first to deliver CD-ROM annual reports to shareholders. Since then, companies such as First Union Corp., Cisco Systems Inc., Elron Electronic Industries Ltd. and Meditech Pharmaceuticals Inc. have used them. With the exception of First Union Corp.'s 1996 annual report, CD-ROM annual reports were delivered in addition to a paper annual report. First Union Corp. solicited consents from shareholders to receive a CD-ROM annual report in lieu of paper.
57 Most companies that have delivered CD-ROM annual reports created a CD-ROM version for only one or two years and then discontinued the practice. Since many shareholders do not have access to CD-ROM drives, these companies may have decided that the cost of creating and delivering CD-ROMs outweighed the benefits of the medium. Other companies still deliver CD-ROM annual reports but vary the level of sophistication of their CD-ROM annual reports from year to year.
58 It is estimated that 70% of NYSE-listed stock is held in street name. Proposed Rule Change Relating to a One-Year Pilot Program for Transmission of Proxy and Other Shareholder Communication Material, Exchange Act Release No. 38406 (Mar. 14, 1997).
59 In general, this right first must be passed through from securities depositories, such as The Depository Trust Company, that today hold record title to most public companies' stock, to participating banks and broker-dealers. A depository typically does this by executing and returning to the company an omnibus proxy that passes voting power through to its participants.
60 17 CFR 240.14a-13 (requiring companies to send proxy materials to beneficial owners of their stock through broker-dealer and bank record holders); 17 CFR 240.14b-1 (requiring brokers in turn to transmit these materials to their customers, the ultimate beneficial owners, upon assurance of reimbursement for reasonable expenses); 17 CFR 240.14b-2 (imposing substantially similar obligation on banks and other custodians of securities for the benefit of others).
61 A. Jared Silverman, Electronic Proxies: Are They in Your Future? , Off-Line, Spring 1996, at 1.
62 John C. Wilcox, Electronic Communication and Proxy Voting: The Governance Implications of Shareholders in Cyberspace , Insights, Mar. 1997, at 8. In late 1996, NCR Corp. was one of the first companies to participate in the direct registration system program in connection with its spin-off from AT&T Corp. Approximately 50 other companies currently participate in the program, many as a result of spin-offs, split-offs or stock splits. Participants include IBM, Ford Motor Co., Bank America, Mobil Corp. and Eli Lilly & Co.
63 The staff is not aware of any broker-dealers or banks that have delivered corporate proxy materials in electronic format to their street-name customers in fulfilling their respective delivery obligations under 17 CFR 240.14b-1 (broker-dealers) or 240.14b-2 (banks).
64 Registered holders selected the medium for delivery by mailing back a consent form to the company. Approximately 1,000 First Union Corp. record shareholders out of 100,000 elected to download the annual report from First Union Corp.'s web site. Approximately 3,000 record shareholders elected to receive CD-ROM annual reports and another 1,500 selected paper and CD-ROM versions. First Union Corp. delivered the proxy statement and proxy card in paper.
65 Intel Corp. mailed paper versions of the company's proxy cards to be returned by mail. Proxy cards were not downloadable from the company's web site. Of Intel Corp.'s 110,000 record holders, 11,000 returned consents to this form of electronic delivery. Cary I. Klafer and Gregory L. Silva, Moving Investor Relations Online , Wallstreetlawyer.com, Aug. 1997, at 1.
66 Electronic Delivery of Stock Plan Prospectuses, Proxy Statements and Annual Reports -- What Companies are Doing , Corp. Executive, Nov./Dec. 1996, at 4. In 1996, Hewlett Packard Co. electronically delivered its annual report, but not its proxy materials, to its employee shareholders. First, the company sent an e-mail to the employee shareholders that it was planning to post its annual report and would not send them a paper version unless they replied requesting paper delivery. Only 5,000 out of 60,000 employee shareholders requested a paper version of the annual report. The other 55,000 employee shareholders then received an e-mail notice containing the annual report's web site address and an icon that linked the employee to the annual report. The web site annual report was also accessible by the public. Hewlett Packard estimates that it saved $300,000 and intends to offer electronic delivery to all registered shareholders next year. D. Craig Nordlund, Electronic Communication with Shareholders , Insights, July 1997, at 18.
67 May 1996 Release, supra note 18, Example 1. This presumption is not available for non-employee shareholders.
68 In 1996, JP Morgan & Co. electronically delivered its proxy statement to employees enrolled in its 401(k) and deferred profit-sharing plans. It avoided personalizing e-mails disclosing the number of shares held by each employee shareholder by delivering the proxy card in paper.
69 ADP Readies for the Massive Tasks of Proxy Season , Inv. Rel. Bus., Mar. 10, 1997, at 12.
70 William O. Gauger, The Proxy Process: Electronic and Telephonic Voting , Insights, Dec. 1995, at 14.
71 First Chicago Gets First Proxies Through the Net , Inv. Rel. Bus., Mar. 24, 1997, at 1. First Chicago Trust Company of New York established an on-line voting pilot program, "Vote-by-Net," in which three public companies participated: McDonald's Corp., First Chicago NBD Corp. and Ameritech Corp.
72 Bell & Howell Adds Cybervoting , Internet Compliance Alert, Aug. 25, 1997, at 7.
73 The federal securities laws do not prescribe whether or how a shareholder meeting should be held, and the Commission does not regulate the meetings' medium. Shareholder meeting conduct is governed by state law and SRO regulation. Most state statutes contemplate meetings held at some location but do not address electronic attendance. Friedman, supra note 25, at 11-12.
74 Tribune Outlook for 1994 "Very Promising," Brumback Tells Stockholders at Annual Meeting; 5 Directors Reelected , Chi. Trib., Apr. 19, 1994. At the Tribune Company's annual meeting, there was no viewer interaction allowed and the audience consisted only of those with a satellite dish.
75 Q & A with Bell & Howell's William White , Off-Line, Spring 1996, at 28. The Bell & Howell Co. meeting content was typical of a regular annual meeting, lasting 45 minutes, including a 15 minute question and answer period. Internet attendees could ask questions via e-mail. Real time viewing or a replay of the meeting was possible.
76 Bell & Howell Co.'s 1997 annual meeting was available on-line again. AT&T Corp. also made its 1997 annual meeting available on-line. AudioNet to Broadcast AT&T's 112th Annual Meeting to Shareholders , PR Newswire, May 19, 1997.
77 The most recent proxy contests involving on-line material related to the CSX Corp.'s and Norfolk Southern Corp.'s contest for Conrail Inc.; Hilton Hotels Corp. and ITT Corp.; and the Western Resources Inc. and Utilicorp United Inc.'s contest for Kansas City Power & Light Co. Web Sites Emerge as Newest Weapon in Proxy Contests , Off-Line, Spring 1996, at 8.
78 For example, CSX Corp.'s web site contained hyperlinks to news sources, a chronological summary of events and easy to use icons and graphics with clear instructions.
79 For example, the Lens Group posts two different sets of documents on its web site. One set, accessible by the public, hyperlinked to relevant news articles, Commission filings, home page, and recent stock quotes relating to the company. Also publicly posted were the Lens Group's action plan and its letters to management, profiles of the relevant company and management, a list of large stockholders and any major lawsuit filings. From the Lens Group's web site, an investor can send an e-mail to the company. The second set of documents is password accessible solely by the Lens Group members. This enables the members to communicate confidentially. Lens Group <http://www.lensinc.com>.
80 Rivel Research Group, supra note 52.
81 Randall Smith, Conference Calls to Big Investors Often Leave Little Guys Hung Up , Wall St. J., June 21, 1995, at C1; Gerard Meuchner, Small Investors Often are the Last to Know; Big Investors, Analysts Can Get Market Information Early , The Plain Dealer, Jan. 21, 1997, at 5C.
82 The Motley Fool has been posting conference call transcripts on its web site at www.fool.com. David Gardner and Tom Gardner, Sorry, Wrong Number , Smart Money, Sept. 1996, at 51.
83 During the past few years, companies have begun to permit any interested investors to access replays of conference calls. Rivel Research Group, supra note 52.
84 The principles in the Commission's release have been embraced by other domestic and foreign regulators who have permitted or are considering permitting electronic delivery. See Alternative Method of Compliance with Requirements for Delivery and Retention of Monthly, Confirmation and Purchase-and-Sale Statements, 62 Fed. Reg. 31507 (June 10, 1997); Interpretation Regarding Use of Electronic Media by Commodity Pool Operators and Commodity Trading Advisers for Delivery of Disclosure Documents and Other Materials, 62 Fed. Reg. 39104 (July 22, 1997). See also Canadian Securities Administrators' Request for Comments 11-401 (June 1997); Australian Securities Commission, Policy Statement 107, Electronic Prospectuses (Sept. 18, 1996).
85 October 1995 Release, supra note 18, at n.27.
86 This permits a company to design versions tailored to various types of investors. Using available technology, any version may use differing levels of text, graphics, audio, or spreadsheets. As long as each version meets the applicable legal requirements, different versions of a document can be delivered to different investors. May 1996 Release, supra note 18, Example 7.
87 See John R. Hewitt, Electronic Delivery Accompanied by Procedural, Record Keeping Hurdles , Off-Line, Spring 1996, at 8. See also Joseph McLaughlin, Booting' the Federal Securities Laws into the 21st Century , Insights, July 1997, at 21.
88 See Report of the Task Force on Disclosure Simplification (March 1996) at III ("[I]n some offerings information outside of the mandated disclosure package -- the registration statement and the traditional prospectus . . . -- is readily available to and accessible by computer literate investors acquiring securities . . . . Because of the Securities Act's broad coverage of offers as interpreted by the Commission, legal uncertainties exist as to whether dissemination of this information may give rise to impermissible offers.") The Task Force examined Commission rules and forms in an effort to streamline disclosure requirements and increase the efficiency of the rules and regulations regarding capital-raising transactions, consistent with investor protection and maintenance of orderly capital markets.
89 See Boris Feldman and David Priebe, Federal Securities Law and the Internet , Cyberspace Law., July 1996, at 4. The Commission staff has clarified that merely referring in a prospectus to the issuer's web site for copies of periodic reports would not cause the web site to be incorporated into the prospectus. See ITT Corp., SEC No-Action Letter (publicly available Dec. 6, 1996) and Baltimore Gas & Electric Co., SEC No-Action Letter (publicly available Jan. 6, 1997).
90 See Harvey L. Pitt and Dixie L. Johnson, Avoiding Spiders on the Web: Rules of Thumb for Issuers Using Web Sites and E-Mail , Wallstreetlawyer.com, June 1997, at 2. The Commission has addressed the posting of an article about a company whose creation or posting is paid for by the company. Pursuant to Section 17(b) of the Securities Act, any amount paid for creating or posting the report must be disclosed in the article. October 1995 Release, supra note 18, Example 22.
91 The staff has issued two no-action letters dealing with electronic roadshows. See supra note 45. See also Linda C. Quinn and Ottilie L. Jarmel, The Road Less Traveled: The Advent of Electronic Roadshows , Insights, July 1997, at 3.
92 The tensions between the prospectus delivery scheme and clearance and settlement timing schedules are noted in the Report of the Task Force on Disclosure Simplification at Section III (Mar. 1996).
93 The staff has issued two no-action letters addressing this issue. See supra note 21.
94 See A. Jared Silverman, Cyberspace Offerings Raise Complex Compliance Issues , N.J. L. J., Dec. 25, 1995, at 10.
Internet jurisdiction issues are affecting many areas of the law. See John Gibeaut, Questions of Authority , A.B.A. J., June 1997, at 42; Gwenn M. Kalow, From the Internet to Court: Exercising Jurisdiction over World Wide Web Communications , 65 Fordham L. Rev. 2241 (1997).
95 Securities Act Concept Release, supra note 7.
96 See Regulation of Communications Among Shareholders, Exchange Act Release No. 31326 (Oct. 16, 1992).
97 17 CFR 240.14a-2(b)(1).
98 17 CFR 240.14a-1(1)(2)(iv).
99 John C. Coffee, Jr., The SEC and The Institutional Investor: A Half-Time Report , 15 Cardozo L. Rev. 837, 840 (1994); Thomas W. Briggs, Shareholder Activism and Insurgency Under the New Proxy Rules , 50 Bus. Law. 99, 100 (1994).
100 Rule 13d-5(b)(1) provides that "[w]hen two or more persons agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of an issuer, the group formed thereby shall be deemed to have acquired beneficial ownership" of the securities for Rule 13(d) reporting purposes.
101 The term "mutual fund," which is not defined in the federal securities laws, refers to an investment company that issues redeemable shares. See Section 5(a)(1) of the Investment Company Act, 15 U.S.C. 80a-5(a)(1) (definition of an "open-end investment company").
102 Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Investing Wisely: Tips from an SEC Insider, Remarks Before Investors' Town Meeting (Aug. 4, 1997) [ Investing Wisely ].
103 Investment Company Institute, Understanding Shareholders' Use of Information and Advisers 29 (1997).
104 Lamp Technologies, Inc., SEC No-Action Letter (publicly available May 29, 1997). In order to obtain access to the web site, a potential subscriber must complete an on-line questionnaire designed to establish the investor's qualification to invest in a fund, pay a subscription fee and use the password assigned to the investor.
105 These reports include updated prospectuses (required to be filed under Section 8 of the Investment Company Act, 15 U.S.C. 80a-8, and the rules thereunder and required to be updated under Section 10(a)(3) of the Securities Act, 15 U.S.C. 77j(a)(3)), and annual and semi-annual reports (Section 30 of the Investment Company Act, 15 U.S.C. 80a30, and the rules thereunder). Investment companies that solicit proxy votes from shareholders generally must comply with Section 20 of the Investment Company Act, 15 U.S.C. 80a-20, and Rule 20a-1 thereunder, 17 CFR 270.20a-1. Rule 20a-1 requires compliance with Regulation 14A, 17 CFR 240.14a-1, et seq., Schedule 14A, 17 CFR 240.14a-101, et seq., and all other applicable rules and regulations adopted pursuant to Section 14(a) of the Securities Exchange Act, 15 U.S.C. 78n(a).
106 Robert A. Robertson, Personal Investing in Cyberspace and the Federal Securities Laws , 23 Sec. Reg. L.J. 347, 349 (1996); and Alexander C. Gavis, The Offering and Distribution of Securities in Cyberspace: A Review of Regulatory and Industry Initiatives , 52 Bus. Law. 317, 319 (1996).
107 Gavis , supra note 106, at 364 n.233, citing Investment Company Institute, Fundamentals, Mutual Fund Research in Brief (Nov./Dec. 1995).
108 Id. at 319-21.
109 See Cliff Alexander, Compliance in Cyberspace , The Investment Lawyer, June 1997, at 2.
110 See Investing Wisely, supra note 102.
111 See Robertson , supra note 106, at 355-356.
113 "Until fairly recently, information was not readily available to the individual investor at a reasonable cost. Today the competition among database publishers is so intense, and the costs of electronic data delivery so low, that any investor can now build and maintain their own portfolio as a do-it-yourselfer. And the action is rapidly moving into cyberspace." Paul B. Farrell, Mutual Funds on the Net , Introduction at xx (1997).
114 Cerulli-Lipper Analytical Report, The State of the Defined Contribution - 401(k) Market 12 (1997).
115 Id. at 14.
116 The Employee Retirement Income Security Act of 1974 ("ERISA"), 29 U.S.C. 1001, et seq. , the primary law governing retirement plans and their sponsors, subjects plan sponsors to a range of fiduciary duties. ERISA, however, provides that if an employee can and does exercise control over the assets in his or her account, then no person who is otherwise a fiduciary with respect to the employee's plan will be liable for any loss that results from the employee's exercise of control. In order for an employee to be deemed to have exercised the requisite control, the employee, among other things, must be offered at least three diversified investment choices, which frequently include mutual funds.
117 Cerulli-Lipper Report , supra note 114, at 16.
118 Gavis , supra note 106, at 364-365.
119 The Investment Company Institute, a trade group for the investment company industry, recently conducted a survey of its members. One hundred eighty-seven of 407 members, representing approximately 72% of the ICI member assets, responded. How Mutual Funds Use the Internet , Fundamentals, Investment Company Institute, Vol. 6, No. 1 (1997). The survey will be referred to as the ICI Survey .
122 The Conduct Rules of the NASD require that investment company advertising and sales literature used by members of the NASD must be submitted for review by NASD Regulation, Inc.
123 It has been estimated that creating and maintaining a transaction-based web site can cost a financial services firm between $5.1 and $23.1 million in its first year. Gabriela Villegas, Forrester: Transaction Web Site Costs Soar Up to $23 Million , Fund Marketing Alert, June 2, 1997, at 1. Costs vary depending upon the type of site: a basic transaction site costs about $5.1 million; a sales site (which can include chat rooms and links) can cost $16 million and an advisory site can cost as much as $23 million. Annual upkeep of a site costs approximately 25% of the initial cost per year. Id. at 11.
124 See generally Christopher I. Strong, Electronic Commerce: Selling Mutual Funds on the Internet <http://www.mfcafe.com/pantry/bps_050597.html>. See also Laurent Belsie, Internet's Instant Access Offers Mixed Blessing , Chi. Sun-Times, Apr. 27, 1997, at 53 ("[E]very time a customer requests a prospectus by phone, it might cost a fund $8 or more to process and mail the information. Over the Internet, it costs only pennies.").
125 See Munder Capital Management, SEC No-Action Letter (publicly available May 17, 1996).
126 See Jane Bryant Quinn, For Online Investors, Some Interesting Sites to Start , Sun-Sentinel, Aug. 5, 1997, at 3D (discussing fees and commissions of broker-dealers). Financenter's web site allows investors to use a free calculator that shows the effects of mutual fund sales fees on performance. See <http://www.smartcalc.com/cgi-bin/smartcalc/MUT4.cgi/FinanCenter>.
127 See, e.g., Vanguard Group Quiz entitled "What is a Mutual Fund?", <http://www.vanguard.com/cgi-bin/M1Quiz>. The American Association of Individual Investors also has courses in subjects including personal finance and investing on its web site. See <http://www.aaii.org.>.
128 See <http://networth.quicken.com>.
129 See October 1995 Release, supra note 18, Example 36.
130 See <http://www.brill.com>.
131 See <http://www.mfea.com>. Features on this web site include hyperlinks to funds' disclosure documents, daily price and performance data, on-line trading sites (where available) and interactive calculators.
132 See <http://www.mfcafe.com>.
133 See, e.g., <http://www.schwab.com/SchwabNOW/SNLibrary/SNLib014/SN014.html>. The cite has information on more than 1,300 funds.
134 Charles Stein, Discount Brokerages a Tough Business , The Boston Globe, Sept. 18, 1997, at C1. See infra p. 61 for more information about fund supermarkets.
136 ICI Survey , supra note 119.
137 Tim Quinson, Mutual Funds Stand By For Computer Trading , Rocky Mountain News, June 6, 1997, at 5B.
138 ICI Survey , supra note 119.
140 See Belsie , supra note 124; M. Rosenthal, Advisers Turn to the Internet , Fund Directions, April 1997, at 6.
141 See Michael A. Hiltzik, The 'Personalized Returns' Issue: Why Can't Funds Do It? L.A. Times, Apr. 15, 1997, at D4, D8.
142 ICI Survey , supra note 119. The October 1995 Release described ways in which this information can be communicated to shareholders electronically consistent with the federal securities laws.
143 In a typical exchange, a shareholder of a fund redeems his or her shares of that fund and receives shares of another fund in an amount equal to the relative net asset value of the shares that were exchanged. Exchanges are subject to the provisions of Section 11 of the Investment Company Act, 15 U.S.C. 80a-11, and the rules thereunder.
144 See, e.g., Vanguard Account Services information <http://majestic1.vanguard.com/PRFL/DA>; Fidelity WebXpress information <http://personal.fidelity.com/trade/index.html>; and Schwab trading demo <http://www.schwab.com/Trading/demo/html/start.html>.
145 PR Newswire, Schwab Announces New Web Alliance With Fund Companies and Expanded Features to Popular Mutual Fund Web Site www.schwab.com/funds , Aug. 7, 1997.
146 ICI Survey , supra note 119.
147 Quinson , supra note 137.
148 The types of security measures taken by funds include procedures that: (1) confirm the legitimacy of the user; (2) determine the data or applications that a person can use; (3) verify that an item has not been changed; (4) protect information from unauthorized disclosure and (5) create audit information. Strong , supra note 124.
149 See, e.g., Steve Winter, Experts to Discuss Security on the Web , Mutual Fund Market News, Sept. 15, 1997, at 12, 16-18; and Steve Winter, Cyberspace, Global Markets are Focus of ICI Ops Conference , Mutual Fund Market News, Sept. 15, 1997, at 1, 38.
150 Rule 22c-1 under the Investment Company Act, 17 CFR 270.22c-1.
151 29 CFR 2550.404c-1(b).
152 An example of a fund group's web site with retirement planning information is the Fidelity's Workplace Savings site, which has interactive savings worksheets, answers to frequently asked retirement questions, and a section with information for plan sponsors. See <http://wps.fidelity.com>. One of the first fund groups to have 401(k) plan information on its web site, Fidelity did not initially include information specific to particular plans on the site. Fidelity currently offers participants in 401(k) plans that are administered by Fidelity transactional capabilities on the site. These capabilities allow participants to perform certain functions, including transferring money between investment options.
153 Cerulli-Lipper Report , supra note 114, at 125.
154 Id. at 126.
155 Id. at 127.
156 Technology has enabled investment companies to fulfill many of their "back office" and compliance obligations more accurately and at less cost than before. Because most of these functions typically are the responsibility of a fund's adviser, they are discussed in Chapter III.
157 Financial Research Corp., Computers as Market Mavens?, Mutual Funds Cafe <http://www.mfcafe.com/pantry/bps_091696.html>.
159 See Global Hub and Spoke Gets Green Light , Fund Action, Apr. 15, 1996, at 1.
160 A mirror fund is a fund whose shares are sold to a particular category of investors that seeks to duplicate the investments of another fund whose shares are sold to a different category of investors.
161 See Banque Indosuez Luxembourg, SEC No-Action Letter (publicly available Dec. 10, 1996).
162 The net asset value of a fund is the value of its assets less its liabilities divided by the number of shares outstanding. Shares of mutual funds must be purchased and redeemed at prices based on their net asset values. A rule under the Investment Company Act requires that the net asset value of an investment company be computed at least once daily, at a specific time or times as established by the fund's board of directors. Rule 22c-1 under the Investment Company Act, 17 CFR 270.22c-1.
163 In a recent speech, Chairman Levitt noted that "Years ago, the problem was a lack of information; today it is a glut of information. Prospectuses have to work for investors, if they are to survive in the new world of information." Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Taking the Mystery Out of Mutual Funds, Remarks Before Boston Citizens Seminar (Feb. 25, 1997).
164 The Commission proposed revisions to Form N-1A, the form used by mutual funds to register under the Investment Company Act and to register their shares under the Securities Act, to make this document more useful to investors. Registration Form Used by Open-End Management Investment Companies, Securities Act Release No. 7398 (Feb. 27, 1997).
165 A new risk/return summary at the beginning of all fund prospectuses and as part of fund profiles would include: (1) a concise narrative description of a fund's overall risks; (2) a bar chart reflecting a fund's returns for ten years, which would illustrate fund risks by showing changes in the fund's performance from year to year; (3) a table accompanying the bar chart that compares the fund's performance to that of a broad-based securities market index; and (4) an improved fee table. The goal of the summary is to assure that all investors have concise summaries of key fund information that they may use to evaluate and compare fund investments.
166 Proposed New Disclosure Option for Open-End Management Investment Companies, Securities Act Release No. 7399 (Feb. 27, 1997), corrected by 62 Fed. Reg. 24160 (May 2, 1997).
167 The proposed profile would not replace the prospectus, and no fund would be required to use the profile. If a fund used a profile, however, an investor could purchase the fund's shares based on the profile or could request and review the fund's prospectus and other information before making an investment decision. All investors would receive a prospectus no later than confirmation of a purchase. A fund would be required to file the fund profile with the Commission prior to its first use.
168 See, e.g., Michael D. Mann, Cross Border Cyberspace: Jurisdiction in Cyberspace: International Implications of Electronic Markets , Wallstreetlawyer.com, June 1997, at 24-26.
169 Section 22 of the Investment Company Act, 15 U.S.C. 80a-22, and Rule 22c-1 thereunder, 17 CFR 270.22c-1.
170 Mutual Funds on the Net , supra note 113 at 337.
171 Id. at 346-47.
172 Charles Schwab & Co., Inc., SEC No-Action Letter (publicly available July 7, 1997) (customer purchase or sale orders placed directly with Schwab or its sub-designee may be deemed to have been received by the relevant fund for purposes of Rule 22c-1, 17 CFR 270.22c-1, at the time that Schwab or its sub-designee accepts the orders).
173 Finance on the Internet, Beware the Cyber-Regulator , The Economist, Aug. 23, 1997, at 56.
174 Section 7(d) of the Investment Company Act, 15 U.S.C. 80a-7(d), generally prohibits an investment company organized outside the United States from making a public offering of its securities in the United States, unless the Commission finds that, "by reason of special circumstances or arrangements, it is both legally and practically feasible effectively to enforce the provisions of" the Investment Company Act against the company. The Commission also must issue an order permitting the company to register. The Commission must find that the issuance of the order is otherwise consistent with the public interest and the protection of investors.
175 See, e.g., Peter Crane, Mutual Fund Investing on the Internet (1997) and the associated web site <http://www.indexfund.com>.
176 See, e.g., Mutual Funds on the Net , supra note 113.
177 See Robert McGough, No-Load Fund Investors Still Buying Advice , Wall St. J., Sept. 11, 1997, at C1.
178 Section 202(a)(11) of the Investment Advisers Act, 15 U.S.C. 80b-2(a)(11). See Applicability of the Investment Advisers Act to Financial Planners, Pension Consultants, and Other Persons Who Provide Investment Advisory Services as a Component of Other Financial Services, Investment Advisers Act Release No. 1092 (Oct. 8, 1987).
179 Section 202(a)(11)(D) of the Investment Advisers Act, 15 U.S.C. 80b-2(a)(11)(D), and Lowe v. SEC , 472 U.S. 181 (1985).
180 Section 203A of the Investment Advisers Act, 15 U.S.C. 80b-3A. Section 203A was added to the Advisers Act by The Investment Advisers Supervision Coordination Act ("Coordination Act"). The Coordination Act is Title III of the National Securities Markets Improvement Act of 1996, Pub. L. No. 104-290, 110 Stat. 3416 (1996).
181 Section 203(b)(3) of the Investment Advisers Act, 15 U.S.C. 80b-3(b)(3).
182 See <http://www.sec.gov/rules/othern/advfaq.htm>.
183 The North American Securities Administrators Association, Inc. is a voluntary association of securities regulators.
184 Section 203A(c) of the Investment Advisers Act, 15 U.S.C. 80b-3A(c).
185 Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. 1633, n.129 (May 15, 1997), corrected by 62 Fed. Reg. 33008 (June 18, 1997).
186 Search of Yahoo! (<http//www.yahoo.com>) on Sept. 24, 1997.
187 For example, the web site for Charles Schwab & Co.'s fund supermarket, OneSource, <http://www.schwab.com/SchwabNOW/SNLibrary/SNLib014/SNO14.html>, allows users to conduct several types of searches. In one search, an investor inputs the investment category, whether the search should be based on three-month, oneyear, five-year, or ten-year performance, whether performance should be as of the recent quarter end or the month end, and whether to show the top ten, twenty-five, or fifty funds.
188 See Investment Strategies Network, Inc. <http://www.isnetwork.com.>.
189 See, e.g., 1-800-Mutuals <http://www.1800mutuals.com>. On this site, after completing a questionnaire concerning the investor's investment goals, investment knowledge, the amount of risk desired and other items, an on-line appointment is made with an "On-line Financial Advisor."
190 See, e.g., Suitability of Investment Advice Provided by Investment Advisers, Investment Advisers Act Release No. 1406 (Mar. 16, 1994).
191 See Chapter II at 57-58 (discussing retirement plans).
192 See Fred Williams, Metlife Allies Offer Investment Advice , Pensions & Investments, Aug. 4, 1997, at 6.
193 Tony Allen-Mills, Screening the Clients , Sunday Times, Aug. 3, 1997.
194 See Marlene Givant Star, Mutual Fund Wrap Assets Grow to $22 Billion , Pensions & Investments, Sept. 16, 1996, at 34.
195 Rule 3a-4 under the Investment Company Act, 17 CFR 270.3a-4. See Status of Investment Advisory Programs under the Investment Company Act of 1940, Investment Company Act Release No. 22579 (Mar. 24, 1997).
196 See SunGard Data Systems Inc. Announces the Agreement to Acquire Premier Solutions Ltd. , PR Newswire, Mar. 24, 1997.
197 See ICA to Roll Out Mutual Fund Wrap Program , Bank Mutual Fund Report, July 15, 1996, at 1.
198 See J.S.K., PMC Rolls Out Allocation Software for Small Banks , Fund Action, July 15, 1996, at 6.
199 Mgrs. Click on, Slowly, With Skepticism , Money Management Letter, June 16, 1997, at S1.
201 Independent RIAs' Use of the Internet Seen Surging , Fund Marketing Alert, Apr. 21, 1997, at 1.
202 See, e.g., Guide to Financial Advisors <http://www.worth.com/articles/Z9410C01.html>.
203 See, e.g., Money Manager Review <http://www.slip.net/~mmreview>.
204 See discussion of fund supermarkets, supra pp. 59-60.
205 Financial Research Corporation, Reaching the RIA <http://www.mfcafe.com/pantry/bps_072197.html>.
206 Independent RIAs , supra note 201.
207 See Pioneer Uses Web to Support Advisers , Financial NetNews, June 30, 1997, at 4.
208 See Oppenheimer Rolls Out New Web Site , Fund Marketing Alert, May 26, 1997, at 2.
209 See, e.g., Mutual Funds Interactive <http://www.brill.com>.
210 See, e.g., The Bankers Trust Global Research Group <http://www.bankerstrust.com/global/index.html>. The Investools web site has information on over 300 newsletters. See <http://www.investools.com/cgibin/Library/nd.pl>. A user can choose a specific newsletter or obtain a list of newsletters pertaining to a specific type of investment.
211 SEC-Live <http://www.seclive.com>. See Jim Ellis, Getting the Net to Help Build Your Portfolio , Business Week, July 15, 1996, at 92, 93.
212 See e.g., DST Systems Inc. <http://www.dstsystems.com/dst/21a6.html>.
213 Section 31 of the Investment Company Act, 15 U.S.C. 80a-31, and the rules thereunder and Section 204 of the Investment Advisers Act, 15 U.S.C. 80b-4, and the rules thereunder.
214 See David Zgodzinski, Hauling in a Net Full of Information: Real-time Stock Quotes, Company Information is Readily Available to Internet Users , The Ottawa Citizen, at A10.
215 See, e.g., Applicability of the Investment Advisers Act to Financial Planners, Investment Advisers Act Release No. 1092 (Oct. 8, 1987).
216 See, e.g., Missouri Innovation Center, Inc., SEC No-Action Letter (publicly available Oct. 17, 1995), Media General Financial Services, Inc., SEC No-Action Letter (publicly available July 20, 1992) and Charles Street Securities, Inc., SEC No-Action Letter (publicly available Feb. 27, 1987).
217 Angel Capital Electronic Network, SEC No-Action Letter (publicly available Oct. 25, 1996). The staff's position for the Ace-net system was based on certain representations and the facts that neither the Network nor the Network Operators would be involved in any purchase or sale negotiations arising from the Network, or give advice regarding the merits or shortcomings of any particular company or transaction.
218 Section 203(b)(3) of the Investment Advisers Act, 15 U.S.C. 80b-3(b)(3).
219 See May 1996 Release, supra note 18.
220 See Discussion of "Private Offerings" in Chapter II.
221 Lamp Technologies, Inc., SEC No-Action Letter (publicly available May 29, 1997).
222 For example, Section 205(a)(2) of the Investment Advisers Act, 15 U.S.C. 80b5(a)(2), requires an adviser to obtain its client's consent if an advisory contract will be assigned to another adviser.
223 Examples of rules that require an adviser to notify or provide disclosure to its clients include: Rule 204-3 under the Investment Advisers Act, 17 CFR 275.204-3, which generally requires an adviser to deliver a written disclosure statement (also termed a "brochure" in the rule ) to its clients at least 48 hours before entering into an advisory contract; Rule 205-3(d) under the Investment Advisers Act, 17 CFR 275.205-3(d), which requires disclosure of certain information by an adviser regarding investment advisory agreements involving performance fees; and Rule 206(4)-2 under the Investment Advisers Act, 17 CFR 275.206(4)-2, which requires disclosure of certain information when an adviser has custody of its clients assets.
224 In the release, the Commission identified, as an example of personal financial information that should be protected, disclosure about agency cross transactions that must be furnished to clients by advisers pursuant to Rule 206(3)-2 under the Investment Advisers Act, 17 CFR 275.206(3)-2.
225 Rule 206(4)-1 under the Investment Advisers Act, 17 CFR 275.206(4)-1.
226 Munder Capital Management, SEC No-Action Letter (publicly available May 17, 1996).
227 Amendment to Investment Adviser Recordkeeping Rule, Investment Advisers Act Release No. 899 (Feb. 15, 1984).
228 Rule 204-2(g) under the Investment Advisers Act, 17 CFR 275.204-2(g). Amendment to Investment Adviser Recordkeeping Rule, Investment Advisers Act Release No. 952 (Jan. 11, 1985). Rule 31a-2 under the Investment Company Act, 17 CFR 270.31a-2. Investment Company Act; Use of Magnetic Tape, Disk, or Other Computer Storage Medium, Investment Company Act Release No. 15410 (Nov. 13, 1986).
229 See Electronic Bulls & Bears , supra note 3, at 129.
230 Division of Market Regulation, The October 1987 Market Break, 7-16 (1988) ("Market Break Report"). See also SEC, Report of the Special Study of the Securities Markets, reprinted in H.R. Doc. No. 95, 88th Cong., 1st Sess. 41-42 (1963) ("Special Study").
231 Market Break Report, supra note 230 at 7-15; Electronic Bulls & Bears, supra note 3, at 129-30. In 1968, the New York Stock Exchange average daily share volume was 12.9 million shares, a fraction of current daily share volume, which for the first part of 1997 has been 501.9 million shares.
232 In a survey conducted among 1,216 investors, Nasdaq found that 49% preferred an investment approach based on education and personal management. In addition, Nasdaq found that younger investors favored self-management, while older investors preferred to rely on a professional to advise them. Nasdaq, A National Survey Among Stock Investors (Jan. 1997).
233 In calendar year 1996, the Commission supervised approximately 8,500 registered broker-dealers with over 62,000 branch offices and over 530,600 registered representatives, 8 registered securities exchanges, the National Association of Securities Dealers and the over-the-counter markets, 15 registered clearing agencies, 748 transfer agents, the Municipal Securities Rulemaking Board, and the Securities Investor Protection Corporation ("SIPC"). U.S. Securities and Exchange Commission Sixty-Second Annual Report 1996 at 39.
234 Section 15 of the Securities Exchange Act, 15 U.S.C. 78.
235 Unless otherwise noted, the term "SRO" in this report refers exclusively to the exchanges and the NASD. Although clearing agencies are also SROs, they do not regulate conduct. Rather, their primary responsibility is to establish financial standards for their members.
236 Division of Market Regulation, Market 2000: An Examination of Current Equity Market Developments, Study IV at IV-1 (1994) ("Market 2000 Study") citing SEC, Institutional Investor Study Report, H. Doc. No. 64, 92nd Cong., 1st Sess. (1971); and SEC, Statement of the Securities and Exchange Commission on the Future Structure of the Securities Markets, 37 Fed. Reg. 5286 (Feb. 4, 1972).
237 See Special Study, supra note 230.
238 Id. at 678.
239 Id. at 126. This led to the creation of the Nasdaq Stock Market. See Market 2000 Study at Study IV-1.
240 SEC, Statement of the Securities and Exchange Commission on the Future Structure of the Securities Markets, Exchange Act Release No. 9484 (Feb. 2, 1972).
241 Pub. L. No. 94-29, 89 Stat. 97 (1975).
242 See generally Market 2000 Study, supra note 236, Study I; and Michael J. Simon and Robert L.D. Colby, The National Market System for Over-the-Counter Stocks , 55 Geo. Wash. L. Rev. 17 (1986) (describing the history and evolution of the National Market System).
243 CTA disseminates last sale information for trades executed on any of the exchanges or through Nasdaq, while CQS collects quotations from the exchanges, Nasdaq, and third market systems and makes them available in a single data stream. See Market 2000 Study, Appendix III (describing the development and operation of the CTA and CQS).
244 SIAC, an exclusive securities information processor registered with the Commission pursuant to Section 11A of the Exchange Act (15 U.S.C. 78k-1), is a communications, service, and securities processing entity jointly owned by the NYSE and the American Stock Exchange ("Amex"). In addition to disseminating information, SIAC operates the NYSE and Amex automation and communications systems supporting trading, market data reporting, and surveillance activities, and supports the National Securities Clearing Corporation's ("NSCC") clearance and settlement systems as well as the systems of NSCC's affiliates, the International Securities Clearing Corporation ("ISCC"), the Government Securities Clearing Corporation ("GSCC"), and the MBS Clearing Corporation ("MBSCC").
245 See Market 2000 Study, supra note 236, Appendix II.
246 Securities traded on a national securities exchange must be registered with the Commission and approved for listing on the exchange. Exchanges may trade securities listed on another exchange pursuant to Commission regulations governing "unlisted trading privileges" or "UTP". The OTC-UTP plan permits participant exchanges to trade certain securities that are quoted on Nasdaq, but not listed on a national securities exchange. See Joint Industry Plan; Order Approving Proposed Reporting Plan for National Market System Securities Traded on an Exchange, Exchange Act Release No. 24407 (Apr. 29, 1987). Currently, the NASD, the Chicago Stock Exchange and the Philadelphia Stock Exchange are full participants in the OTC-UTP plan, and the Boston Stock Exchange is a limited participant. See Joint Industry Plan, Exchange Act Release No. 36985 (Mar. 18, 1996).
247 See The Nasdaq Stock Market 1996 Fact Book & Company Directory (1996); NYSE Fact Book 1995 Data (1996). See also Nasdaq's web site at <http://www.nasdaq.com> and the NYSE's web site at <http://www.nyse.com>.
248 The exception is the Cincinnati Stock Exchange, which began phasing out its trading floor in 1976 and is now fully automated. See infra at 91.
249 Today, all exchanges offer systems which allow members to route orders electronically to the exchange for execution. The NYSE's SuperDOT (Designated Order Turnaround) system enables securities firms to transmit market and limit orders in all NYSE-listed securities directly to the specialist post. The Boston Stock Exchange's ("BSE") BSE Automated Communications and Order Routing Network, or BEACON, and the Pacific Exchange's ("PCX") Pacific Computerized Order Access system, or P/COAST, provide automatic execution in addition to order routing to the specialists' posts. Similar order routing/executions system are operated by the Amex (Automated Post Execution Reporting System, or AutoPERS), the Chicago Board Options Exchange (Order Routing System, or ORS, and Retail Automated Execution System, or RAES), the Chicago Stock Exchange (Midwest Automatic Execution System, or MAX), and the Philadelphia Stock Exchange (Phlx Automated Communications and Execution System, or PACE).
250 The NYSE has posted a description of the ITP on its web site. See <http://www.nyse.com>.
251 See Order Granting Approval to Proposed Rule Change Relating to the Exchange's Wireless Data Communications Initiatives, Exchange Act Release No. 36156 (Aug. 25, 1995).
252 CBOE 1996 Annual Report.
253 See Order Granting Approval to Proposed Rule Change Relating to the Implementation of a Wireless Data Communications Infrastructure, Exchange Act Release No. 37728 (Sept. 26, 1996).
254 See Dean Tomasula, Traders Gain Split-Second Advantage by Going Wireless , Wall Street & Technology, Aug. 1996, at 48-50.
255 The use of hand held terminals and wireless communications devices is not free from controversy. Several exchanges have attempted to place restrictions on the use of such devices for trading off the floor of the exchange, so that no firm could make markets unless they are physically present on the floor. At least one firm has criticized this approach. Letter from Earl Nemser, Managing Director, Interactive Brokers LLC to Jonathan G. Katz, Secretary, SEC, regarding SR-PSE-97-02 (Mar. 11, 1997). See also Letter from David Bohan, Counsel to Interactive Brokers LLC, to Jonathan G. Katz, Secretary, SEC, regarding SRCBOE95-48 (Nov. 2, 1995).
256 Exchanges Expand Wireless Trading Systems, Wall Street Letter, Technology -- Special Supplement, June 23, 1997, at 1; Amex Rolls out Broker Cell Phones, Wall Street & Technology -- Special Supplement, June 23, 1997, at 4.
257 Order Approving Proposed Rule Change Creating the Chicago Match System, Exchange Act Release No. 35030 (Nov. 30, 1994). The Chicago Match System ceased operating in 1996.
258 Order Approving Proposed Rule Change and Notice of Filing and Order Granting Accelerated Approval of Amendment Numbers 1, 2 and 3 to Proposed Rule Change Relating to the PCX Application of the Optimark System, Exchange Act Release No. 39086 (Sept. 17, 1997). Similarly, a futures exchange, the Chicago Board of Trade, developed an automated trading system for U.S. Treasury securities so that members could hedge their futures positions. The CBOT and its partners established a broker-dealer, Chicago Board Brokerage, Inc., to operate the system, and established a clearing organization, CCOS, to clear transactions matched through the system. See Chicago Board Brokerage, SEC No-Action Letter (publicly available Dec. 12, 1995) (granting no-action relief from exchange registration); Order Approving Application for Exemption from Registration as a Clearing Agency, Exchange Act Release No. 36573 (Dec. 12, 1995) (granting temporary exemption from clearing agency registration to CCOS). The system is not yet operational.
259 See SEC, Report on the Practice of Preferencing at 25 (Apr. 11, 1997).
260 SelectNet allows market makers to negotiate and execute orders with one another through Nasdaq terminals, rather than by telephone. Through SelectNet, a member can direct buy or sell orders in Nasdaq securities to a single market maker (preferenced orders) or broadcast orders to all market makers in the security. They can negotiate the terms of orders through counter-offers by sending messages through SelectNet.
SOES is a comprehensive automatic order execution system that allows for the electronic execution of small orders in Nasdaq securities. SOES automatically executes unpreferenced orders in rotation against those market makers who are at the best quoted bid or offer on Nasdaq at the time the order is entered. With the agreement of the market maker, SOES orders also may be routed or "preferenced" to a particular market maker for execution at the inside market, regardless of what price the preferenced market maker is quoting.
261 See infra pp. 98-101.
262 Jane Morrissey, Nasdaq Dials MCI for Help , PC Week, July 30, 1997, at 6.
263 Market 2000, supra note 236, Study II at II-10.
264 In 1996, 104,636 million shares traded on the NYSE, and 7,486 million shares of NYSE-listed companies were traded by third market makers. Nasdaq Stock Market 1996 Fact Book and Company Directory at 7. See also Anatomy of Satellite Trading in the National Market System for NYSE-listed Stocks , Journal of Financial Research, June 22, 1995.
265 See Anatomy of Satellite Trading, supra note 264.
266 See Order Execution Obligations, Exchange Act Release No. 37619A (Sept. 6, 1996) and Payment for Order Flow, Exchange Act Release No. 34902 (Oct. 27, 1994).
267 NYSE Fact Book 1995 Data at 24.
268 NSCC is a clearing agency registered with the Commission pursuant to Section 17A under the Exchange Act. It was established in 1976, and is owned equally by the NYSE, Amex, and the NASD.
269 OCC issues, clears, and settles options on several types of underlying assets, including common and preferred stock, currencies, stock indices, and interest rate composites. It is jointly owned by Amex, CBOE, PCX, and Phlx.
270 TIMS utilizes an option pricing model to project the cost of liquidating each clearing member's long and short equity option positions in the event of a "worst case" theoretical change in the price of the underlying securities. This projected liquidation cost is then used by TIMS to calculate for each clearing member a margin requirement to cover that cost. See Proposed Rule Change Concerning Equity TIMS, Exchange Act Release No. 37985 (Nov. 25, 1996).
271 The Options Clearing Corporation 1996 Annual Report.
272 Proposed Rule Change Relating to Customer Order Executions, Exchange Act Release No. 36092 (Aug. 11, 1995).
273 A number of clearing organizations have received Commission approval to participate in the CMS service. See Richard R. Lindsey and Anthony P. Pecora, 10 Years After: Regulatory Developments in the Securities Markets Since the 1987 Market Break (1997).
274 In 1993 the Commission adopted Rule 15c6-1, which established three business days as the standard settlement time frame for most broker-dealer securities transactions. Rule 15c6-1, promulgated under the Exchange Act, became effective on June 7, 1995.
275 See infra p. 106.
276 The Commission approved several proposed rule changes filed by registered clearing agencies to facilitate the conversion to same-day funds settlement. See, e.g. , Proposed Rule Change Modifying the Same-Day Funds Settlement System, Exchange Act Release No. 35720 (May 16, 1995).
277 Sarah Stirland, Trading Bonds on the Web: a Brokers' Broker Does It First , The Bond Buyer, Jan. 29, 1997, at 30.
278 Robert Sales, Bond Market Waits for Electronic Trading Champ , Wall Street & Technology, Mar. 1997, at 32.
279 Id. at 33.
280 The Bond Market Trade Association, Electronic Bond Trading Systems Expected to Expand Significantly Over Next One to Three Years, PSA Survey Shows <http://www.psa.com/PP/electra.htm>. See also Richard Richtmeyer, Survey Shows Bond Market is Warming up to Electronic Trading , The Bond Buyer (Aug. 20, 1997) at 30.
281 Robert Zipf, How the Bond Market Works , 118 et seq. (2d ed. 1997). Information on some types of debt is published in The Blue List for municipal bonds and National Quotation Bureau "yellow sheets" for corporate bonds.
282 According to the NYSE, by the end of 1996, ABS had a subscriber base of 58 member firms. See NYSE 1996 Fact Book, at 83.
283 The NASD designates fifty of the most liquid bonds as "FIPS securities." Quotes for these bonds are disseminated on the FIPS system, but members must also report trades for non-FIPS designated securities by the end of the day following execution. This promotes transparency and facilitates market surveillance. See Order Approving Proposed Rule Change and Amendment No. 1 Relating to the Proposed Operation of a Pricing System for Certain High Yield Fixed Income Securities, Exchange Act Release No. 32019 (Mar. 19, 1993). The FIPS system has been operating since April 1994.
284 The government debt market is highly influenced by the primary dealers' fiduciary obligations to the Federal Reserve. For example, if the primary dealers fail to honor their transmitted indications of interest, they may lose their primary dealer status with the Federal Reserve.
285 Richard Richtmeyer, Survey Shows Bond Market is Warming up to Electronic Trading , The Bond Buyer, Aug. 20, 1997, at 30.
286 Robert Sales, Bond Market Waits for Electronic Champ , Wall Street & Technology, Mar. 1997, at 32.
287 The Bond Market Trade Association, An Investor's Guide to Corporate Bonds <http://www.psa.com/pubcat/IGCORP/big.htm>.
288 See Proposed Rule Change Relating to Reports of Sales or Purchases, Exchange Act Release No. 34955 (Nov. 9, 1994).
289 See Proposed Rule Change Relating to Reports of Sales and Purchases, Exchange Act Release No. 37998 (Nov. 29, 1996).
290 Trading systems not registered as exchanges have been referred to in previous Commission releases as "proprietary trading systems," "broker-dealer trading systems," and "electronic communications networks." The latter two terms are defined in Rules 17a-23 and 11Ac1-1 under the Securities Exchange Act, 17 CFR 240.17a-23 and 240.11Ac-1, respectively. The term "alternative trading systems" refers generally to automated systems that centralize, display, match, cross, or otherwise execute trading interest, but that are not currently registered with the Commission as national securities exchanges or operated by a registered securities association. Regulation of Exchanges, Exchange Act Release No. 38672 (May 23, 1997) (the "Exchange Act Concept Release").
291 Instinet, Tradebook, Island and other "matching" systems allow participants to display firm, priced orders to other participants and to execute automatically against other orders in the system. POSIT and other "crossing" systems allow participants to enter unpriced orders, which are then executed with matching interest at a single price, typically derived from the primary public market for each crossed security. AZX and other "single-price auction" systems allow participants to enter priced orders, which the system then compares to determine the single price at which the largest volume of orders can be executed. All orders are then matched and executed at that price. Id. See also Market 2000 Study, supra 236, Appendix IV.
292 The Commission staff has given operators of alternative trading systems assurances that it will not recommend enforcement action if those systems operated without registering as national securities exchanges. For a brief description of all systems issued no-action letters by the end of 1993, see Market 2000 Study, supra note 236, Appendix IV. See also Tradebook, SEC-No-Action Letter (publicly available Dec. 31, 1996); Niphix, SEC No-Action Letter (publicly available Apr. 18, 1997); The Institutional Real Estate Clearinghouse System, SEC No-Action Letter (publicly available May 28, 1996); Chicago Board Brokerage, Inc. and Clearing Corporation for Options and Securities, SEC No-Action Letter (publicly available Dec. 13, 1995). Although AZX is considered to be an alternative trading system, it is not registered as a broker-dealer. Rather, it is an exchange operating pursuant to a limited volume exemption from registration as a national securities exchange.
293 Exchange Act Concept Release, supra note 290.
294 As broker-dealers, these systems are subject to oversight by SROs that themselves operate exchanges or trading systems, which raises competitive concerns. Also, these systems are not fully integrated into the National Market System, so that activity on them is not fully disclosed or accessible by public investors. The trading activity on these systems may not be adequately monitored for market manipulation and fraud. Moreover, these trading systems have no obligation to provide investors a fair opportunity to participate in their systems or to treat their participants fairly; nor do they have an obligation to ensure that they have sufficient capacity to handle trading demands. Id.
295 For example, the Commission proposed, withdrew, and then reproposed Rule 15c2-10 under the Exchange Act. This Rule was a compromise regulatory regime that would have combined elements of broker-dealer regulation with elements of exchange regulation. A summary of the Commission's consideration of these systems can be found in Proprietary Trading Systems, Exchange Act Release No. 26708 (Apr. 11, 1989) (reproposing Rule 15c2-10). This proposal was eventually withdrawn, and the Commission instead adopted a recordkeeping and reporting rule for broker-dealers operating such systems in an effort to collect additional information about the operation of these systems. See Proprietary Trading Systems, Exchange Act Release No. 33621 (Feb. 14, 1994) (withdrawing proposed Rule 15c2-10) and Recordkeeping and Reporting Requirements for Trading Systems, Exchange Act Release No. 35124 (Dec. 20, 1994) (adopting Rule 17a-23).
296 The Act added Section 36 of the Exchange Act, 15 U.S.C. 78mm, which authorizes the Commission to conditionally or unconditionally exempt any person, security, or transaction, or any class thereof, from any provision of the Exchange Act or rule thereunder, so long as the exemption is necessary or appropriate in the public interest and is consistent with the protection of investors.
297 Exchange Act Concept Release, supra note 290.
298 Electronic Bulls & Bears , supra note 3, at 135.
299 Id. at 19.
300 John Byrne, Catching the Order Routing Wave: the Big Kahuna of the Industry is 'Connectivity,' Traders Magazine, Oct. 1996, at 22.
301 For example, Bloomberg L.P.'s electronic network, which began as a computerized data service for Treasury bonds, currently offers access to more than 4,000 functions created by Bloomberg and third parties. These functions include electronic trading, order routing, and straight-through processing (interfaces to back office services) as well as the more traditional domestic and foreign stock market and financial products information, including research and analysis.
302 The North American securities industry as a whole spent an estimated $11.5 billion on information and communication technologies in 1996. Some of the largest firms are spending close to $1 billion each. The Tower Group/SIA, Technology Trends in the Securities Industry - 1997, at 38 ("SIA Technology Survey").
303 See Kathryn George, To Build or to Buy a New Trading System , Traders Magazine, Feb. 1997, at 26; Annette Kondo and Ignatius Chithelen, Financial Workstations Emerge as "Modern Marvels," Wall Street Computer Rev., Dec. 1988, at 42.
304 POSIT, AZX, Instinet and SelectNet are examples of execution centers to which orders might be routed. Open orders in listed securities might also be routed to an exchange or to OTC market makers for "third market" execution. In addition, these systems might also permit users to advertise trading interest through electronic bulletin boards such as AutEx.
305 See Kathryn George, To Build or to Buy a New Trading System , Traders Magazine, Feb. 1997, at 26. Salomon Brothers, Merrill Lynch, Piper Jaffrey and Morgan Stanley are among those broker-dealers who have built their own order management systems.
306 Automatic Data Processing Service, Inc. ("ADP") is one such vendor providing connections to the exchanges' automated routing and execution system, such as SuperDot. Another is Davidge Systems, which offers DavNet, a routing network for trading orders and execution information between exchanges, data services and broker-dealers. ADP claims that it "processes over 20% of the trades on U.S. stock exchanges." Davidge claims that its systems are responsible for communicating 6-8% of the NYSE's daily volume. John Byrne, Catching the Order Routing Wave: the Big Kahuna of the Industry is 'Connectivity,' Traders Magazine, Oct. 1996, at 22.
307 SIA Technology Survey, supra note 302, at 34-35.
308 See Ivy Schmerken, Outsourcing Megadeals Drive the New IT Economy , Wall Street & Technology, Apr. 1996, at 36. Outsourcing may potentially raise regulatory issues since the companies that provide outsourcing are generally not regulated entities.
309 Typically, large institutional investors have internal trading desks that receive orders from the portfolio managers and relay them to outside broker-dealers for execution.
310 As of January, 1996, only about 10% of the large buy-side firms, managing $1 billion or more, were equipped with order management systems. Kathleen Golden, Order Management Turns up the Heat , Wall Street & Technology, Jan. 1996, at 46.
311 AutEx is an electronic database and network for trade order indications. AutEx enables its subscribers to communicate indications of interest in buying and selling large blocks of equity securities. It is used by over 3,000 institutional investors and broker-dealers. See AutEx <http://www.tfn.com/THOMSON/trading/htm#AutEx>.
312 GovPx is a quotation system that displays information on pricing and trading volume in government securities by interdealer brokers.
313 Institutional investors trade directly through alternative trading systems, and may also have, through a link to a broker-dealer, direct access to exchange automated entry systems like SuperDot. Although the federal securities laws limit direct exchange trading privileges to members of the exchange (which, by statute, must be broker-dealers), non-member clients currently enjoy electronic trading capabilities that are closely akin to the direct trading privileges enjoyed by the member. These trading capabilities provided by members are more or less direct, depending on the method employed. Institutional investors have begun to demand more direct access for a number of reasons. The more direct an investor's access is to an exchange, the greater its control over trades and the faster such trades are executed. In addition, the chances of re-keying errors and potential abuses such as frontrunning are diminished.
314 The largest of these is Merrin Financial Services' ITN. Information vendors such as Bloomberg, Thomson and Bridge have also added features that permit order routing from institutions to broker-dealers. See John Byrne, Catching the Order Routing Wave: the Big Kahuna of the Industry is 'Connectivity,' Traders Magazine, Oct. 1996, at 22.
315 The FIX protocol was developed by a consortium of institutions and broker-dealers, which included Salomon Brothers, Goldman Sachs, Morgan Stanley, PaineWebber, Fidelity Capital Markets, Fidelity Management and Research, Alliance, State Street, Scudder and Twentieth Century. Since its development, the protocol has been refined and expanded based on input from numerous industry participants. All FIX users become members of a "Technical Committee," which meets several times a year to discuss and debate modifications, expansions and implementation. The actual protocol is maintained by a "Steering Committee" selected from among members of the Technical Committee. See Welcome to the Fix Web <http://www.fixprotocol.org>.
316 Vendors that have traditionally used proprietary communications protocols have begun modifying their services to be compatible with the FIX protocol. These include Merrin Financial, Thomson Financial Services, Davidge Data Systems and Bloomberg L.P. Kathleen Golden, Making FIX Stick , Wall Street & Technology, Oct. 1995, at 54, 55.
317 Brandon Coffey, Integrating the Front and Back Office , Wall Street & Technology, Jan. 1997, at 14. See also SIA Technology Survey, supra note 302, at 30.
318 SIA Technology Survey, supra note 302, at 8. Only 8% of firms with less than 500 employees have Internet sites.
319 Electronic Bulls & Bears , supra note 3, at 141.
320 The Forrester Report: Brokers and the Web at 2 (Sept. 1996).
321 1996 Annual SIA Investor Survey (Oct. 1996).
322 For example, customers trading through E*Trade Securities ("E*Trade") pay $14.95 for a trade of 1500 listed shares (market order), and $19.95 for an OTC trade. Customers trading through e.Schwab, Charles Schwab's "deep" discount brokerage account, which allows customers to place trades only electronically, pay $29.95 per trade up to 1,000 shares, plus $.03 per share for every share over 1,000. Customers with a traditional discount account at Charles Schwab pay a minimum of $39 per trade, and may place trades electronically, over the telephone or in person at a Schwab branch office. Customers of Datek Securities Corp.'s "Datek On-Line" pay $9.95 a trade. Andrew Leckey, Brokerages Scramble for Online Bandwagon , St. Louis Post Dispatch, June 6, 1997, at 21C.
323 Merrill's Mixed Up Internet Trading Strategy , Bank Technology News, June 1997.
324 In the event that there is a discrepancy between an electronic order and the customer's account, such as a lack of funds or an order to sell 1000 shares when the customer only owns 100, the order is automatically printed out of the computer for manual handling. The order is checked against the customer's account manually, and either re-entered or the customer is contacted, as appropriate.
325 The broker-dealer, Jack White & Co., offers a system called InterConnect to cross buy and sell orders at a price between the national best bid and offer. InterConnect is not a continuous system; rather, there are multiple crossing sessions throughout the day. Customers correctly enter orders on InterConnect by telephone. Jennifer Zajac, How to Save Money When You Trade Your Nasdaq Stocks , Money, Apr. 1997, at 82.
326 1996 Annual SIA Investor Survey (Oct. 1996).
327 NASD, A National Survey among Stock Investors (1997).
328 See, e.g. , the following web sites: NYSE <http://www.nyse.com>; NASD <http://www.nasd.com>; NASD Regulation <http://www.nasdr.com>; Nasdaq <http://www.nasdaq.com>; PCX <http://www.pacificex.com>; Phlx <http://www.phlx.com>; Chx <http://www.chicagostockex.com>, and Amex <http://www.amex.com>.
329 See, e.g. , DTC <http://www.dtc.org>; NSCC <http://www.nscc.com>; MSBCC <http://www.mbscc.com>; GSCC <http://www.gscc.com>; and OCC <http://www.optionsclearing.com>.
330 See <http://www.msrb.org>.
331 See Exchange Act Concept Release, supra note 290, text accompanying nn.9-14.
332 For example, execution and confirmation systems offered through one vendor, Bloomberg, include CS First Boston's CPTrade (commercial paper); Salomon Brothers' Express Trading Access (equities); Deutsche Morgan Grenfell's Autobahn Electronic Trading System (U.S. government bonds) and Morgan Stanley's Repo Link (repurchase agreements).
333 Section 3(a)(22) of the Securities Exchange Act, 15 U.S.C. 78c(a)(22), defines a "securities information processor" as "any person engaged in the business of i) collecting, processing, or preparing for distribution or publication, or assisting, participating in, or coordinating the distribution and publication of, information with respect to transactions in or quotations for any security...or (ii) distributing or publishing...on a current and continuing basis, information with respect to such transactions or quotation." This definition potentially covers a broad range of entities that facilitate communications among investors, intermediaries, and markets. See Exchange Act Concept Release, supra note 290, at text accompanying nn.233-37.
334 For example, Deutsche Borse, the Frankfurt equities exchange, provides remote access in London, Amsterdam, Paris, and Zurich, and has attracted 44 remote members. OM Stockholm (formerly the Stockholm Stock Exchange), has remote members in the U.K., Denmark, Norway, Finland, and Switzerland. Laura Covill, Survival of the Fittest , ABI/INFORM, Aug. 1996, at 60.
335 Exchange Act Concept Release, supra note 290.
336 Both of these alternatives provide regulatory certainty, but they also have significant disadvantages. For example, under the home country approach, investor protection may be compromised by different levels of disclosure and different market practices. On the other hand, requiring foreign markets to register as exchanges in the U.S. may subject them unnecessarily to duplicative or conflicting obligations. See Exchange Act Concept Release, supra note 290, at 121-27 for a more complete discussion of the advantages and disadvantages of these two regulatory approaches.
337 See Order Execution Obligations, Exchange Act Release No. 37619A (Sept. 6, 1996).
338 17 CFR 240.11Ac1-4.
339 17 CFR 240.11Ac1-1.
340 See Order Execution Obligations, Exchange Act Release No. 38110 (Jan. 2, 1997) and Order Execution Obligations, Exchange Act Release No. 38139 (Jan. 8, 1997).
341 The four systems are: Instinet; Archipelago (originally called TONTO), which is operated by Terra Nova Trading, LLC; Island, which is sponsored by Datek Securities Inc.; and Tradebook, which is operated by Bloomberg Tradebook LLC. See Instinet Real Time Trading Service, SEC No-Action Letters (publicly available Jan. 17, 1997, June 27, 1997 and Aug. 27, 1997); TONTO System, SEC No-Action Letters (publicly available Jan. 17, 1997, June 27, 1997 and Aug. 27, 1997); Island System, SEC No-Action Letters (publicly available Jan. 17, 1997, June 27, 1997 and Aug. 27, 1997); and Tradebook System, SEC No-Action Letters (publicly available Jan. 17, 1997, June 27, 1997 and Aug. 27, 1997).
342 Exchange Act Rule 11Ac1-1(c)(5)(ii), 17 CFR 240.11A1c-1(c)(5)(ii). The ECN Display Alternative provides that an exchange specialist or OTC market maker has complied with the ECN Amendment if the ECN it uses: 1) provides to a SRO for inclusion into the public quotation system the prices and sizes of such orders at the highest buy price and lowest sell price for the security; and 2) provides, to any broker or dealer, the ability to effect transactions with such orders that is the equivalent of any broker or dealer to effect a transaction with an exchange specialist or OTC market maker pursuant to the rules of the SRO receiving the prices from the ECN for inclusion in the public quotation system. The four current ECNs all comply with the second provision through a linkage with Nasdaq's SelectNet service.
343 See <http://www.nasdaq.com>.
344 Very broadly, a "derivative" product is a financial instrument that derives its value from the performance of other assets, including securities, currency exchange rates, or indexes. Derivative products encompass a wide array of financial contracts, including swaps, futures, options and forwards, and some combination of these contracts. See Net Capital Rule Concept Release, Exchange Act Release No. 32256 (May 4, 1993); Saul S. Cohen, The Challenge of Derivatives , 63 Ford. L. Rev. 1993, 2000 (1995); Henry T.C. Hu, Hedging Expectations: "Derivative Reality" and the Law of Finance of the Corporate Objective , 73 Tex. L. Rev. 895 (1995).
345 See Cohen, supra note 344, at 2000. See also Net Capital Rule Concept Release, supra note 344; Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, before the Subcommittee on Telecommunications and Finance, Committee on Energy and Commerce, U.S. House of Representatives 2 (May 25, 1994).
346 See Henry T.C. Hu, Swaps, the Modern Process of Financial Innovation and the Vulnerability of a Regulatory Paradigm , 138 U.Pa. L. Rev. 333, 334-39 (1989). See also International Council of Securities Association, Overview and Recommendations on OTC Derivatives, at 3 (1994).
347 Derivatives permit corporations and local governments to lower their funding costs. They can also be a cheaper and more liquid way of attaining desired exposure than a position in the cash market. Overall, derivatives can provide an entity with a more sophisticated means to manage or shift portfolio or business risk.
348 See generally William K. Maready, Jr., Regulating for Disaster: Federal Attempts to Control the Derivatives Market , 31 Wake Forest L. Rev. 885, 887-97 (1996) (discussing several incidents involving losses from derivatives transactions); Testimony, supra note 345, at 2.
349 See Wall Street & Technology Product Digest, Fall 1996, at 10. Some of these systems are standardized: a number of vendors offer software packages for risk management that incorporate statistical models.
350 Disclosure of Accounting Policies for Derivative Financial Instruments, Securities Act Release No. 7386 (Jan. 31, 1997).
351 Net Capital Rule, Exchange Act Release No. 38248 (Feb. 6, 1997).
352 See May 1996 Release, supra note 18.
353 For a more thorough description of the problems experienced during the 1987 market break, see Market Break Report, supra note 230, chs. 7-9.
354 See ARP I at notes 13 - 15. On October 13, 1989, the Dow Jones Industrial Average fell 190.58 points (6.91%). A few days later, an earthquake in Northern California disrupted trading at the PCX for five days. On November 10, 1989, the NYSE delayed opening due to a fire in the building that housed SIAC.
355 Automated Systems of Self-Regulatory Organizations, Exchange Act Release No. 27445 (Nov. 16, 1989) ("ARP I Release").
356 Automated Systems of Self-Regulatory Organizations, Exchange Act Release No. 29185 (May 9, 1991) ("ARP II Release").
357 ARP II Release. Although the ARP I and ARP II are addressed to the exchanges and Nasdaq, clearing agencies are now included in the program.
358 See Schwab's Site on Web Shut for Part of Day , Wall St. J., June 12, 1997, at B5; Broker's Trial by Computer: Fidelity Still Battling with Disruptions Caused by New Systems , Financial Times, Nov. 6, 1996, at 8 (reporting problems experienced by Fidelity Brokerage Services, a U.K. subsidiary of Fidelity Investments) and On-Line Trades Surge, Causing Some Glitches , Wall St. J., July 18,1996, at C1.
359 See, e.g. , Denise Papplardo, Trouble Haunts the 'Net; Brownouts, Fiber Cuts and Congestion are Becoming Typical , Network World, Aug. 4, 1997, at 33; Bad Internet Outage is Caused by Firm that Controls Domain Name System , Wall St. J., July 18, 1997, at B6; Louise Kehoe and Paul Taylor, Microsoft Shuts Down E-mail; Overloading Forces Closure of Worldwide Message Service , Financial Times, Apr. 18, 1997, at 3; David Hilzenrath, Customer Surge Slows AOL Service , Washington Post, Dec. 20, 1996, at G3.
360 The Division of Market Regulation, in conjunction with the Division of Corporation Finance, issued a brief advice letter to Spring Street Brewing Company (Apr. 17, 1996) and a no-action letter to Real Goods Trading Corporation (publicly available June 24, 1996). Since the Real Goods Letter, the staff has provided two additional letters to issuers that wanted to establish web sites allowing investors to post their interest in buying and selling their securities. See PerfectData Corp., SEC No-Action Letter (publicly available Aug. 5, 1996) and The Flamemaster Corporation, SEC No-Action Letter (publicly available Oct. 29, 1996).
361 Angel Capital Electronic Network, SEC No-Action Letter (publicly available Oct. 25, 1996).
362 Charles Schwab & Co., Inc., SEC No-Action Letter (publicly available Nov. 27, 1996).
363 17 CFR 240.17a-4. Rule 17a-4 requires the retention of, among other things, originals of all communications received and copies of all communications sent by such member, broker, or dealer, including inter-office memoranda and communications, that relate to its business as such. The amendments to 17a-4 supersede a 1993 no-action letter regarding the use of optical disk storage technology for record retention. See Reporting Requirements for Brokers or Dealers under the Securities Exchange Act of 1934, Exchange Act Release No. 38245 (Feb. 5, 1997) (adopting the amendments to Rule 17a-4).
364 Id. The rules to which this no-action position apply are listed in the release. The release also specifically states that the records required by two rules related to penny stock transactions, Rules 15g-2 and 15g-9, 17 CFR 240.15g-2 and 15g-9, should be maintained and preserved in paper format. These rules require broker-dealers to obtain from a customer prior to effecting transactions in penny stocks: (1) a manually signed acknowledgment of the receipt of a risk disclosure document, (2) a written agreement to transactions involving penny stocks and (3) a manually signed and dated copy of a written suitability statement.
365 17 CFR 240.17a-4(f)(2)(ii).
366 17 CFR 240.17a-4(f)(3).
368 Reporting Requirements for Brokers or Dealers under the Securities Exchange Act of 1934, Exchange Act Release No. 38245 (Feb. 5, 1997).
369 See e.g. , Hal Lux, Compliance Follies , Institutional Investor, July 1997, at 24.
370 Specifically, Article III, Subsections 35(a)(1) and (2) of the Rules of Fair Practice and Subsections 8(a)(1) and (2) of the Government Securities Rules were amended.
371 Proposed Rule Change Relating to Advertising and Sales Literature, Exchange Act Release No. 36076 (Aug. 9, 1995).
372 Specifically, Article III, Subsection 35(b)(1) of the Rules of Fair Practice and Subsection 8(b)(1) of the Government Securities Rules were amended in this regard. Although virtually all advertising and sales literature must be filed with the NASD prior to the first time it is used, in many cases, subsequent use of the same items may be done without filing. Internal approval by a registered principal, however, remains required. See NASD Rule 2210, Communications with the Public .
373 Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change and Amendment No. 1 to the Proposed Rule Change by the New York Stock Exchange, Inc., Relating to NYSE Rules 342, "Offices---Approval, Supervision and Control," 440, "Books and Records," and 472, "Communications with the Public," Exchange Act Release No. 37941 (Nov. 13, 1996); Notice of Filing of Proposed Rule Change by the National Association of Securities Dealers, Inc. Relating to Supervision and Record Retention Rules, Exchange Act Release No. 38548 (Apr. 25, 1997). These proposals apply only to correspondence; other communications with the public, such as advertisements, sales literature, and research reports, would continue to be subject to prior approval. See also NASD Notice to Members No. 96-50, Supervisory and Other Obligations Related to Use of Electronic Mail. Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change and Amendment No. 1 to the Proposed Rule Change by the New York Stock Exchange, Inc., Relating to NYSE Rules 342, "Offices---Approval, Supervision and Control," 440, "Books and Records," and 472, "Communications with the Public," Exchange Act Release No. 37941 (Nov. 13, 1996) (regarding NYSE-96-26) and Proposed Rule Change Relating to Supervision and Record Retention Rules, Exchange Act Release No. 38548 (Apr. 25, 1997) (regarding NASD-97-24).
374 See Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning Fraud in the "Micro Cap" Market, Before the Subcomm. on Investigations of the Sen. Comm. on Governmental Affairs (Sept. 22, 1997).
375 OIEA, Investor Beware: Investment Fraud and Abuse Travel to Cyberspace <http://www.sec.gov/consumer/cyberfr.htm>.
376 In the Matter of Omnigene Diagnostics, Inc., Exchange Act Release No. 37966 (Nov. 19, 1996). Section 12(k) of the Securities Exchange Act authorizes the Commission to enter orders that summarily suspend trading in a security for a period of up to ten business days. Such temporary suspensions may be ordered when the Commission finds that they are required by the public interest and for the protection of investors. In general, trading suspensions are entered when the Commission has questions regarding the accuracy of publicly disseminated statements made with regard to an issuer or its stock. Typical issues will be the accuracy and adequacy of disclosures about sales, revenue and earnings, valuation and ownership of assets and business operations and prospects.
377 SEC Division of Enforcement Complaint Center <http://www.sec.gov/enforce/comctr.htm>.
378 Sound, video and animation can be added to give an appearance that will rival professionally designed web pages. The Commission action SEC v. Octagon Technology Group, Inc., et al., Litigation Release No. 14942 (June 11, 1996), concerned individuals who posted an impressive looking web page on the Internet to attract potential purchasers of non-existent bonds.
379 Privacy Act of 1974, 5 U.S.C. 552a.
380 The Electronic Communications Privacy Act of 1986 extensively revised the federal wiretap laws, codified at 18 U.S.C. 2510, et seq .
381 Section 10(b) of the Exchange Act makes it unlawful "[t]o use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors." 15 U.S.C. 78j(b).
Rule 10b-5 implements Section 10(b) by making it unlawful, in connection with the purchase or sale of any security,
(a) To employ any device, scheme or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.
17 CFR 240.10b-5.
382 Section 17(a) of the Securities Act, 15 U.S.C. 77q(a).
383 Section 5 of the Securities Act, 17 U.S.C. 77e.
384 See, e.g. , Section 6 of the Exchange Act, 17 U.S.C. 78f (registration of exchanges); Section 15(a) of the Exchange Act, 17 U.S.C. 78o (registration of brokers).
385 See , William R. McLucas, Mark B. Lewis and Alma M. Angotti, Common Sense, Flexibility and Enforcement of the Federal Securities Laws , 51 Bus. Law. 1221, 1222 (1996) ("From the foreign payments program to the more recent initiatives in the municipal securities markets, the SEC has tried to address new issues without the benefit, or the hindrance, of precise proscriptions. Instead, the agency has relied on the general proscriptions contained in the federal securities laws and has tried to apply them practically and with common sense.")
386 See, e.g., Section 21(d)(1) of the Exchange Act, 15 U.S.C. 78u(d)(1).
387 The Commission first obtained significant authority to seek civil penalties in its insider trading cases, pursuant to the Insider Trading Sanctions Act of 1984 ("ITSA") and the Insider Trading and Securities Fraud Enforcement Act of 1988 ("ITSFEA"), provisions that are codified in Section 21A of the Exchange Act, 15 U.S.C. 78u-1. The Securities Enforcement Remedies and Penny Stock Reform Act of 1990 ("Remedies Act") expanded this authority by providing penalties for any violations of the federal securities laws other than insider trading covered by ITSA and ITSFEA. The civil penalty provisions are codified in various sections of the statutes administered by the Commission, including Section 21(d)(3) of the Exchange Act, 15 U.S.C. 78u(d)(3). The statutory civil penalties, as adjusted for inflation, are set out in Table I to Rule 1001 of the Commission's Rules of Practice, 17 CFR 201.1001.
388 The Commission's authority to seek equitable relief in the form of a court ordered prohibition from acting in the capacity of a corporate officer or director was affirmed by the Remedies Act, in a provision codified as Section 21(d)(2) of the Exchange Act, 15 U.S.C. 78u(d)(2).
389 See, e.g., Section 21C of the Exchange Act, 15 U.S.C. 78u-3.
390 See, e.g., Sections 15(b)(4) and (6) of the Exchange Act, 15 U.S.C. 15o(b)(4) and (6).
391 See, e.g., Section 32 of the Exchange Act, 15 U.S.C. 78ff. Under the Exchange Act, individuals who willfully violate the statute may be fined up to $1,000,000 and may be imprisoned for up to ten years. Corporations and entities other than individuals are subject to fines of up to $2,500,000.
392 See, e.g., Section 21(d)(1) of the Exchange Act, 15 U.S.C. 78u(d)(1) ("The Commission may transmit such evidence as may be available concerning such acts or practices as may constitute a violation of any provision of this title or the rules or regulations thereunder to the Attorney General, who may, in his discretion, institute the necessary criminal proceedings under this title.")
393 SEC v. I-Net Providers , Litigation Release No. 15219 (Jan. 17, 1997).
394 SEC v. Pleasure Time, Inc., d/b/a Telephone Information Systems, et al. , Litigation Release No. 14440 (Mar. 15, 1995).
395 Litigation Release No. 15106 (Oct. 3, 1996).
396 The Commission has obtained a preliminary injunction and other emergency relief in this case. See also SEC v. Spencer , Litigation Release No. 14856 (Mar. 29, 1996); and SEC v. Frye , Litigation Release No. 14720 (Nov. 15, 1995).
397 Litigation Release No. 15004 (Aug. 7, 1996).
398 Without admitting or denying the Commission's allegations, Sellin and the other defendants in that action consented to the entry of permanent injunctions prohibiting them from future violations of the anti-fraud provisions.
399 Litigation Release No. 14598 (Aug. 10, 1995). This action has been settled with respect to two defendants and remains pending with respect to one other.
400 Stock manipulations are formally prohibited with respect to exchange-listed securities by Section 9(a) of the Exchange Act, 17 U.S.C. 78i(a). In addition, the manipulation of the price of any security typically violates the basic anti-fraud provisions, discussed above.
401 Alternatively, a short seller could seek to disseminate false information about a security in order to drive down the share price.
402 Litigation Release No. 15153 (Nov. 7, 1996).
403 See SEC v. Huttoe , Litigation Release No. 15237 (Jan. 31, 1997). On January 31, 1997, Huttoe was sentenced, pursuant to a plea agreement, to a federal prison term of 46 months followed by two years of supervised release and a $10,000 fine for one count of securities fraud and one count of money laundering for his role in the scheme.
404 Litigation Release No. 14942 (June 11, 1996).
405 See, Joseph J. Cella III and John Reed Stark, SEC Enforcement and the Internet: Meeting the Challenge of the Next Millennium , 52 Bus. Law. 815, 826 (1997).
406 Section 17(b) of the Securities Act, 17 U.S.C. 77q(b), provides that:
It shall be unlawful for any person, by the use of any means or instruments of transportation or communication in interstate commerce or by the use of the mails, to publish, give publicity to, or circulate any notice, circular, advertisement, newspaper, article, letter, investment service, or communication which, though not purporting to offer a security for sale, describes such security for a consideration received or to be received, directly or indirectly, from an issuer, underwriter, or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof.
407 SEC v. George Chelekis, et al. , Litigation Release No. 15264 (Feb. 25, 1997).
408 The defendants in that matter consented to an order enjoining them from future violations of the securities laws and requiring the payment of disgorgement and civil penalties.
409 See SEC v. Huttoe , Litigation Release No. 15490 (Sept. 12, 1997). Melcher was sentenced to 12 months imprisonment, followed by two years of supervised release and was ordered to pay a fine of $20,000.
410 Itoba Ltd. v. LEP Group PLC , 54 F.3d 118 (2d Cir. 1995); Bersch v. Drexel Firestone, Inc. , 519 F.2d 974 (2d Cir.), cert. denied , 423 U.S. 1018 (1975); Schoenbaum v. Firstbrook , 405 F.2d 200 (2d Cir.), rev'd on other grounds , 405 F.2d 215 (2d Cir. 1968) ( en banc ), cert. denied , 395 U.S. 906 (1969); Leasco Data Processing Equip. Corp. v. Maxwell , 468 F.2d 1326 (2d Cir. 1972).
411 See, e.g. , SEC v. Bosque Carillo , 1997 WL 322290 (11th Cir. June 30, 1997). See generally , International Shoe Co. v. Washington , 326 U.S. 310 (1945) ( quoting Milliken v. Meyer , 311 U.S. 437 (1940)).
412 See, e.g. , SEC v. Wye Resources, Inc. , Litigation Release No. 15073 (Sept. 26, 1996). In Wye , the Commission filed an action against a Canadian corporation and its president, a resident of Newfoundland, based upon their targeting of U.S. investors through the Internet. The Commission obtained injunctions and an order requiring the individual defendant to pay a civil penalty of $25,000. In addition, the Commission filed a related action against certain U.S. stockbrokers, and obtained orders requiring the disgorgement of $426,790 plus interest, representing their ill-gotten gains in the matter. In the Matter of Broad Capital Assoc., Inc. , Securities Act Release No. 7338 (Sept. 26, 1996).
413 The Commission has entered into 31 such arrangements for cooperation with foreign authorities. Consequently, with growing ease, the Commission is able to obtain information from many jurisdictions, including developing and developed markets, to pursue its enforcement cases.
414 These initiatives take different forms, including developing supervisory information-sharing arrangements, coordinating approaches to specific regulatory issues, working to overcome jurisdictional barriers to cross-border oversight and facilitating the offer of securities in the U.S. as part of an international distribution.
415 With over 130 members, IOSCO is the predominant international forum for collaboration among the securities regulatory community. Since its inception in 1974, IOSCO's membership has expanded to include most of the world's securities regulators from both developed and emerging markets.
416 The Commission, with its Mexican counterpart, promoted the formation of COSRA in 1992 to enhance the efforts of countries in the Americas and the Caribbean to develop sound securities markets that are fair to all investors. COSRA's membership represents both developed and emerging markets.
417 See <http://www.iosco.org/presscomm970922.html>.
418 After attending this program, the Brazil Comissao de Valores Mobiliarios commenced its own Internet enforcement and surveillance program. Brazil Regulator to Launch Cyber-Surveillance , Internet Compliance Reporter, Sept. 8, 1977.
419 As part of the Commission's international training program, the Commission offers two International Training Institutes each year. The International Institute for Securities Market Development is an intensive two-week program held each spring at the Commission's headquarters, designed for senior regulatory and stock exchange officials. The International Institute for Securities Enforcement and Market Oversight is a one-week program offered during the fall, which focuses on practical techniques for conducting investigations, market surveillance, and inspections of broker-dealers, mutual funds and investment advisers. Through these two annual institutes and other training programs the Commission provides training in the U.S. each year for over 250 foreign participants from over 80 countries.
420 See IOSCO <http://www.iosco.org>.http://www.sec.gov/news/studies/techrp97.htm