URL Ref.: http://www.freeadvice.com/law/553us.htm [abridged]

THE INTERNET AND THE CYBERSECURITIES MARKETPLACE
by Denis T. Rice, Esq. discussing the offer and sale of securities on the Internet.

FLASH: As of October 19, 1998 Congress had passed and sent to the President for signature the Securities Litigation Uniform Standards Act that closes what some considered "legal loopholes" that had allowed shareholders to sue companies under state laws in circumstances in which recovery was not possible under Federal law. The material below has NOT yet been updated to reflect the new law.

WHAT ARE THE FEDERAL SECURITIES LAWS?

In the 1920s many companies issued, and stock brokers promoted, stocks and bonds on the basis of glittering promises of fantastic profits without disclosing meaningful information to investors. The stock market kept on going up and up until the wave of speculative euphoria ended with the Stock Market Crash of 1929 and the Great Depression that followed.

In an effort to curb future excesses, and provide full and fair disclosure to investors, Congress enacted the Federal Securities laws and created the Securities and Exchange Commission (SEC) to administer them.

The primary Federal Securities laws are the Securities Act of 1933 ("Securities Act"), the Securities Exchange Act of 1934 ("Exchange Act"), the Investment Company Act of 1940 ("Investment Company Act"), and the Investment Advisers Act of 1940 ("Advisers Act").

WHAT DO THESE FEDERAL SECURITIES LAWS COVER?

The Securities Act generally governs new offerings. Often referred to as the "truth in securities" law, the Securities Act requires that investors receive financial and other significant information concerning securities being newly offered for public sale. The Securities act also prohibits deceit, misrepresentations and other fraud in the offer or sale of securities, whether newly issued or already outstanding.

The Exchange Act provides for investor access to current financial and other information regarding securities, particularly those that trade publicly on exchanges or over-the-counter. The Exchange Act prohibits companies, securities brokerage firms and others from engaging in fraudulent and unfair behavior, such as sales practice abuses and insider trading. The Exchange Act governs the conduct and registration of securities brokers and dealers, the operation of the securities exchanges, such as the New York Stock Exchange, and the self regulatory organization known as the National Association of Securities Dealers, Inc. It also sets forth rules concerning the operation of proxy solicitations by companies and shareholders, tender offers and buying securities on credit (margin).

The Investment Company Act governs activities of investment companies, such as mutual funds, that are primarily serve as collective investment vehicles for others.

The Advisers Act establishes a pattern of regulating those who manage or advise others on how to invest. In some respects, it resembles the Exchange Act that governs the conduct of securities brokers and dealers, and generally requires that firms compensated for advising others about securities investment to register with the SEC and conform to statutory standards designed to protect investors.

ARE THERE ALSO STATE SECURITIES LAWS?

Yes. While the Federal Securities Laws are by far the most important laws governing securities and the securities markets generally, most states also have "Blue Sky Laws" that apply to a company that wishes to sell securities to the state's residents, or to persons who wish to engage in business as a securities broker or dealer, or to give investment advice to others.

Although the focus of this section will be on the provisions of the Federal Securities Laws that impact investors, in many cases a state's laws may give the investor who loses money or is defrauded in the securities markets far greater protections than are available under Federal law. Often, when litigation is necessary, attorneys make claims under both Federal and applicable state law.

WHAT IS A "SECURITY"?

The term ''security'' is broadly defined to include stocks -- which term includes mutual fund shares - and bonds, and also such things as notes, evidences of indebtedness, certificates of participation in any profit-sharing agreement, certificates of deposit, and, plus many types of puts, calls, straddles and options on any security or group or index of securities.

The definition encompasses many things that people might ordinarily not \be considered a "security", such as fractional undivided interests in oil, gas, or other mineral rights, and "investment contracts", and "variable" life insurance policies and "variable" annuities, whose cash values or benefits are tied to the performance of an investment account.

Certain "securities" are, in turn, exempted from various provisions of the Federal Securities Laws. For example, securities of the Federal Government and those issued or guaranteed by a "bank" are "exempted" from requirements that would apply to securities of industrial companies.

WHAT IS A PROSPECTUS AND HOW DOES IT HELP ME?

The Securities Act generally requires companies issuing new securities, including stocks or bonds, to file a Registration Statement with the SEC before they can raise capital from the public. This is supposed to enable the new investors to have "full disclosure" of all "material facts" investors would find important in making an investment decision.

The Registration Statement includes a "prospectus" which is the legal offering or "selling" document. The company - the "issuer" of the securities - must describe in the prospectus the important facts about its business operations, financial condition, and management. Everyone who buys the new issue, as well as anyone who is made an offer to purchase the securities, must have access to the prospectus.

DOES THE SEC APPROVE COMPANIES' OFFERINGS OF SECURITIES OR PROSPECTUSES?

No. The SEC never evaluates the merits of offerings, or determine if the securities are "good" investments.

The SEC staff generally does review Registration Statements, but it does not independently verify their truthfulness or completeness. For example, the Registration Statements must contain financial statements prepared by certified public accountants. The staff of the SEC does not conduct its own independent review of the financial statements, and if they seem in order, that is the end of the matter. The same is true with other aspects of the Registration Statement. When the staff concludes its review, it declares the Registration Statement "effective" and the company issuing the securities may sell them.

The issuing company, its key officers and directors, and the experts named in the Registration Statement, such as the accountants, are responsible for (and liable in the event of) any false statements of a material fact, or misleading omissions.

SUPPOSE THE PROSPECTUS CONTAINS FALSE OR MISLEADING INFORMATION?

You have rights to recover your money from the issuing company, its controlling persons and the underwriters. However, you will want to consult with an attorney quickly to protect your rights.

Under some circumstances the attorney may be able to represent you and other persons who have also been defrauded in a "class action".

WHAT IS AN "IPO"?

An IPO is an Initial Public Offering of shares by a company.

WHAT IS A "HOT ISSUE"?

A "hot issue" is an IPO that is in heavy demand. In such a case the indications of interest from prospective purchasers received by the broker-dealers underwriting the issue far exceeds the number of shares that the issuing company plans to sell. For example, if Hot Biotech Inc. proposes to issue 5 million shares of its stock at $12 per share, yet there is a demand for 10 million shares, that is a "hot issue".

Once the stock is issued, their share price of the shares would be expected to rise well above the $12 offering price, because some of those who wanted to buy it at $12 and could not get any would go out into the market to buy it at higher price. Extremely hot issues have been known to double and triple the same day, so the same shares that were sold at $12 in the morning, would be selling for $36 by the end of the day.

While sometimes the issuing company is able to increase the number of shares it will be selling to reflect the heavy demand, or raise the price at which it offers shares, generally this will not dampen enthusiasms for a very hot issue. Of course, sometimes the demand has been whipped up far beyond the true value of the shares, and although they may show a dramatic short term rise, they may quickly fall back to approach or go below the original offering price. Other times they keep on climbing.

WHAT IS "SPINNING"?

The practice of allocating shares in what are expected to be "hot issues" to favored customers of a broker-dealer. The favored customers can then immediately sell or "spin" them off, realizing a substantial profit between the original offering price (the $12 share in the above example) and the price the shares immediately climbed to when sold, perhaps the same day or shortly thereafter (the $36).

The entire issue as to how brokers decide to whom to allocate shares is a sticky one. Is it "fair" and appropriate for brokers to treat good, established customers better than strangers? Are brokers using the shares of hot issues to in effect "bribe" persons with whom they have or want other relationships? Are the underwriters being subjected to a type of "extortion" forcing them to allocate shares in hot issues from people who can direct or influence their firm's trades, or future underwriting?

The issues involve questions of "improper appropriation of corporate opportunity" by employees for their personal benefit, rather than that of their employers, "commercial bribery", "extortion" and "breach of fiduciary duties". In short, "spinning" is now a very "hot" topic under the Securities Laws.

SUPPOSE A BROKER DEFRAUDS ME?

You would have rights to recover from the broker's firm and the broker who defrauded you both under the Federal Securities laws, and the appropriate state's laws.

While securities brokers and dealers are subject to regulation both by the SEC and state regulators, and by the National Association of Securities Dealers [NASD] and the Stock Exchanges the firm belongs to, and you may wish to file a complaint with them, their focus is usually on disciplining the broker and his or her firm to prevent future misconduct, not on recouping your investment.

If you believe you were harmed financially by any deceptive, misleading, fraudulent or manipulative act by a broker, you should see our section on Broker Disputes which suggests several approaches to obtaining recourse against the broker and his or her firm, and retain an attorney to assist you in pursuing your claim.

SUPPOSE A COMPANY DEFRAUDS ME?

The Federal Securities Laws, and state laws, give you very significant rights. Very often if you were defrauded, others who purchased shares at or about the same time were also defrauded. Thus, Securities Law cases are often handled as part of a "Class Action" lawsuit. A "class action" is a civil suit brought by one or more people on behalf of themselves and others who are similarly situated. In other words, everyone is in a substantially similar circumstance where the common issues are the ones most critical to the lawsuit. For example, suppose a

company issues an allegedly false press release and the stock goes from $10 to $15 but when the truth comes out the stock falls to $6 per share. A class action could be brought on behalf of all the stockholders who purchased shares after the company issued deceptive news and before the truth came out. Each member of the class allegedly suffered some harm as a result of the alleged wrong. While the damages of each member of the class will vary - someone who bought 1,000 shares at $15 each would be 10 times more impacted than a person who bought 100 shares at $15 – but the critical issue is whether the press release was deceptive, and that is common to all class members.

WHAT IS "INSIDER TRADING"?

"Insider trading" generally refers to the purchasing or selling of securities of a company while in possession of material information that has not been generally disclosed in the marketplace.

For example, suppose a company makes an important discovery of a valuable mining asset, as Texas Gulf Sulfur did in the 1960's, or invents a new drug that is likely to have a major impact on the bottom line, as Pfizer did with its impotence drug in 1998, or announces that it is making an important acquisition, is being acquired, or merging, as Citicorp and Travelers did in 1998. Such news would likely cause the price of the company's shares to increase. If insiders who have that knowledge buy, they win, while the person selling his or her shares who did not have that knowledge will lose.

Similarly, if a company hides bad news that would be likely to cause the market price of its shares to drop, while members of corporate management who knew the bad news sold the shares, that likely would be insider trading. For example, in April 1998 Cendant announced that it had discovered "accounting irregularities". Its financial statements had significantly overstated its income. When the news was released Cendant's shares dropped from the $35 per share level to about $18 per share (46%) in just one day. In a recently filed Class Action lawsuit, it was alleged several members of Cendant's top management sold 2 million shares shares at the high price before the bad news was released.

IS INSIDER TRADING ILLEGAL?

Yes. Although at one time insider trading was a generally accepted way of life, and people just assumed that company insiders and their friends would profit from their special access to information, it is now illegal under various Federal Securities Laws. While good news and bad news is inevitable, the rules prohibit insiders in possession of such news from trading or causing others to trade on such news before it is generally released to the marketplace.

Insider trading damages those on the other side of the transactions -- for example if an insider sold Cendant shares the day before the bad news was announced at $35, it is clear he would be better off than the person or firm who bought the shares from him at $35, only to see them drop to $18 once the bad news hit the market.

Insider trading also damages the stock market generally because it impacts investor confidence, deters people from investing (people are reluctant to invest if they see the market as a rigged situation), and harms companies whose confidential proprietary information is used to benefit only select individuals rather than the company as a whole.

IS THERE ANY SPECIAL STATUTE THAT DEFINES "INSIDER TRADING"?

Not really. The rules prohibiting insider trading were largely made by the SEC and the courts. The SEC first identified insider trading as a type of securities fraud coming within its broad rules defining and prohibiting manipulative and deceptive acts in 1961.

There are two bases for holding parties responsible for insider trading. The "special relationship" or "classical" theory is that an insider, because of his or her special relationship to the company, owes a fiduciary duty to the company's shareholders not to trade on insider information for personal gain. The "misappropriation theory" does not focus on the insider's duty to the company, but on the basis that if the the trader obtained the information as a result of a breach of any fiduciary duty to the company, there is liability.

In addition to the classic insider, such as corporate officers and directors, insider liability may be asserted against others who gain access to insider information, such as a person who receives a "tip" from an insider, attorneys, accountants and printers who have access to that information.

In addition to being illegal under the Securities Laws, insider trading is often attacked criminally under the Federal mail fraud and wire fraud statutes. (For an excellent book on the subject, the 1,237-page Insider Trading by William S. K. Wang and Marc I. Steinberg was published by Little, Brown & Company in 1997.)

ARE ALL COMPANIES SUBJECT TO THE SECURITIES LAWS?

Yes, and no. While some companies are exempt from the registration and reporting requirements of the Securities Laws, most companies are subject to the anti-fraud rules.

SHOULD MY COMPANY "GO PUBLIC"?

Apart from the critical business considerations, such as why would anyone want to buy your shares, what can your shares realistically sell for, who will actually sell the shares and who will maintain a market in them, if your company needs additional capital, "going public" may or may not be a viable option.

If your company is in the very early stages of development, it may be better to seek loans from financial institutions or the Small Business Administration. Other alternatives include raising money by selling securities in transactions that are exempt from the registration process.

There are benefits and obligations that come from raising capital through a public offering. While the benefits are attractive, be sure you are ready to assume the significant new obligations.

HOW DOES A BUSINESS REGISTER A PUBLIC OFFERING?

If you decide on a registered public offering, the Securities Act requires your company to file a registration statement with the SEC before the company can offer its securities for sale. You cannot actually sell the securities until the SEC staff declares it "effective," even though registration statements become public immediately upon filing.

A registration statement is NOT a fill-in-the-blank form, like a tax return. Preparing a Registration Statement requires a very experienced team consisting of at least a securities attorney and an accountant. For an example of some of the complex "form" documents that lawyers have to adapt to client needs, Jefren Publishing has posted a number of typical forms on its Website.

WHAT SHOULD A PROSPECTUS INCLUDE?

A well designed prospectus ideally would be similar to a well crafted brochure, providing readable information, but WITHOUT ANY HYPE. Unfortunately, most prospectuses are dull, boring, long documents with all the excitement of the telephone directory, because any omissions can place you in severe jeopardy.

Companies must clearly describe any risks prominently in the prospectus, often at the very beginning. Risks that must be disclosed -- often at length -- include any lack of business operating history, any past problems with the company or members of its management, any adverse economic conditions in the company’s particular industry, the company’s competitive disadvantages, the regulatory structure and dangers in the event of non-compliance, any lack of a market for the securities offered, and the lack of assurance that there will be a market, the "dilution" between the price the new shareholders are paying and the low price the insiders bought their shares at, and dependence upon key personnel. In short, some prospectuses appear to be a combination prospectus

The company also must describe in the prospectus its business, its properties, its competition, its officers and directors and their compensation, transactions between the company and its officers and directors, legal proceedings involving the company or its officers and directors, the plan for distributing the securities; and the intended use of the proceeds of the offering. You also need to include financial statements audited by an independent certified public accountant.

IF A COMPANY BECOMES PUBLIC, WHAT DISCLOSURES MUST IT REGULARLY MAKE?

Companies are required to report unless they fall below certain "thresholds." Filing obligations are suspended if the company has fewer than 300 shareholders, or has fewer than 500 shareholders and less than $10 million in total assets for its last three fiscal years, unless the company’s securities are listed on a Stock Exchange or NASDAQ.

Reporting companies must report information about their operations, their officers, directors, and certain shareholders (including salary, various fringe benefits, and transactions between the company and management), the financial condition of the business (including financial statements audited by an independent certified public accountant), and their competitive position and material terms of contracts or lease agreements. All of this information becomes publicly available.

WHAT ARE THE "PROXY STATEMENTS" I GET FROM COMPANIES?

Most publicly held companies must comply with the SEC's proxy rules whenever they seek a shareholder vote on corporate matters. These rules require the company to provide a proxy statement to its shareholders, together with a proxy card when soliciting proxies. Proxy statements discuss management and executive compensation, along with descriptions of the matters up for a vote.

The proxy rules also require your company to send an annual report to shareholders if there will be an election of directors. These reports contain much of the same information that a company must file with the SEC, including audited financial statements. The proxy rules also govern when your company must provide shareholder lists to investors and when it must include a shareholder proposal in the proxy statement.

CAN I LEARN ABOUT INSIDERS' PURCHASES AND SALES OF COMPANY SECURITIES?

The Exchange Act requires a company's directors and officers, as well as shareholders who own more than 10% of a class equity securities registered under the Exchange Act, to report their transactions involving the company's equity securities to the SEC. It also establishes mechanisms for a company to recover "short swing" profits, those profits an insider realizes from a purchase and sale of a company security within a six-month period. In addition, the Exchange Act prohibits short selling by these persons of any class of the company's securities.

Share ownership among directors and key officers of many companies also must be shown in their company's proxy statement.

Persons who acquire more than five percent of the outstanding shares of a class of stock in most publicly held companies must file beneficial owner reports until their holdings drop below five percent. These filings contain information about the owners as well as their investment intentions, providing investors and the company with information about accumulations of securities that may potentially change or influence company management and policies.

WHAT IS A TENDER OFFER?

If outsiders seek to make a takeover attempt, or tender offer for a public company, the SEC tender offer rules often apply. The filings require the person making the tender offer provide detailed information to the public and shareholders about the tender offer and the plans of the persons making the tender offer. The target company is also subject to provisions of the tender offer rules.

The tender offer rules also set time limits for the tender offer and provide other protections to shareholders

CAN I RAISE MONEY WITHOUT ALL THESE COMPLEXITIES?

Yes! Your company's securities offering may qualify for one of several exemptions from the SEC's registration requirements. However, all securities transactions, even exempt transactions, are subject to the antifraud provisions of the Federal Securities Laws. This means that you and your company will be responsible for false or misleading statements (whether oral or written).

While the government enforces the Federal Securities Laws through criminal, civil and administrative proceedings, there is also the possibility of private law suits from anyone who loses money (or does not make all that she or he would have made) as a result of violations of the Federal Securities Laws.

IF I WANT TO SELL SECURITIES ONLY LOCALLY, IS THE SEC INVOLVED?

If the offering is purely local, it may qualify for the "Intrastate Offering Exemption" from the SEC's registration requirements.

To qualify for the intrastate offering exemption, a company must be incorporated in the same state where it is offering the securities and carry out a very significant amount of its business in that state. It may offer the securities only to residents of that state, and may not sell any of the securities to anyone not a resident of that state. (Experience shows that in practice it is very difficult to make sure offers are only being made to state residents, especially if someone is helping the company sell the issue.) If even one share of the securities are offered or sold to just one out-of-state person, the Intrastate exemption may be lost. Similarly, if an in-state purchaser of the shares resells any of them to a person who resides outside the state within a short period of time after the company's offering is complete (the usual test is nine months), the entire transaction, including the original sales, might violate the Securities Act.

Most of the benefits of the Intrastate exemption can be obtained by adhering to SEC Rule 147's "safe harbor" provisions. Our advice to companies seeking to raise capital is never to rely on the Intrastate exemption unless a securities lawyer is closely involved in the process. Further, even if an offering may qualify for an exemption from registration under the Federal Securities Act of 1933, it may well have to register and/or qualify under the Blue Sky Laws of the state in which the offering is made.

CAN I SELL SECURITIES ONLY TO WEALTHY INVESTORS?

There is a "Private Offering Exemption" under Section 4(2) of the Securities Act which exempts from registration "transactions by an issuer not involving any public offering."

To qualify for this exemption, the purchasers of the securities must have enough knowledge and experience in finance and business matters to evaluate the risks and merits of the investment (be a "sophisticated investor"), or be able to bear the investment's economic risk, and have access to the type of information normally provided in a prospectus, and agree not to resell or distribute the securities to the public.

In addition, you may not use any form of public solicitation or general advertising in connection with the offering.

IS THERE A LIMIT ON THE NUMBER OF INVESTORS I MAY APPROACH?

Ask a securities lawyer, please. While there are no precise limits of the private offering exemption, as the number of purchasers increases and their relationship to the company and its management becomes more remote, it is more difficult to show that the transaction qualifies for the exemption. Also, if you offer securities to even one person who does not meet the necessary conditions, the entire offering may be in violation of the Securities Act.

Rule 506, another "safe harbor" rule, provides objective standards that you can rely on to meet the requirements of this exemption.

OKAY, IS THERE A SIMPLIFIED PROSPECTUS?

Yes, sort of. Regulation A provides an exemption for public offerings not exceeding $5 million in any 12-month period. Instead of a formal prospectus, the company files an offering statement (consisting of a notification, offering circular, and exhibits) with the SEC for review.

Purchasers receive an offering circular that is similar in content to a prospectus. Like registered offerings, the securities can be offered publicly and are not "restricted," meaning they are freely tradable in the secondary market after the offering. The principal advantages of Regulation A offerings, as opposed to full registration, are the financial statements are simpler and don't need to be audited and there are not the same stringent on-going reporting obligations until the company has more than $10 million in total assets and more than 500 shareholders.

I HEARD ABOUT A "504 OFFERING". WHAT IS THAT?

Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities in a 12-month period. Your company may use this exemption so long as it has a specified business objective. The good news is that Rule 504 does not require issuers to give disclosure documents to investors, you can sell securities to an unlimited number of persons, you can use general solicitation or advertising to market the securities, and purchasers receive securities that are not "restricted." This means that they may sell their securities in the open market without registration or other sales limits imposed on privately placed securities.

There is also a Rule 505 offering possible for sales of securities totaling up to $5 million in any 12-month period to an unlimited number of "accredited investors" and up to 35 other persons (who do not need to satisfy the sophistication or wealth standards associated with other exemptions). However, the use of a securities attorney is almost essential in any offering of securities if you value your company, you assets or your freedom.

ARE THERE STATE LAW REQUIREMENTS IN ADDITION TO FEDERAL ONES?

Yes! The Federal government and state governments each have their own securities laws and regulations. If your company is selling securities, it must comply with both the Federal and state securities laws. Even if a particular offering is exempt under the Federal securities laws, that does not necessarily mean that it is exempt from a state's laws. Historically states have used a "full disclosure" approach, a "fairness" approach, or both.

The full disclosure approach is comparable to that followed by the SEC. The states require a businesses' securities offerings disclose to investors all information needed to make an informed investment decision, and state officials may review the offering material to see if it omits any apparent issues. Other states analyze public offerings using substantive "fairness standards" designed to assure that the terms and structure of the offerings are fair to investors.

The North American Securities Administrators Association ("NASAA"), Small Corporate Offering Registration ("SCOR") is a simplified "question and answer" registration form that companies can use as the disclosure document for investors in more than 40 states. Even so, you’d better have a lawyer help you!

…an outstanding article "THE INTERNET AND THE CYBERSECURITIES MARKETPLACE" by Denis T. Rice, Esq. discussing the offer and sale of securities on the Internet.

FreeAdvice.com® is the leading legal site for consumers and small businesses. It provides general legal information to help people understand their legal rights in 100 legal topics, but is not a substitute for personal legal advice from an attorney.

You are welcome to view AttorneyPages.com® for your own personal, non-commercial purposes, AS IS, subject to our disclaimer and conditions of use.

This article [above] was last updated [as written] January 09, 1999.