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SEC commissioner Laura Unger published a report on the Internet last fall entitled “On-Line Brokerage: Keeping Apace of Cyberspace.” In this report, she cites sources that estimate on-line brokerage assets at $415 billion in 1999 — projected to grow to more than $3 trillion by 2003. With such assets growing at an ever-expanding rate, practitioners and their clients rightly conclude that the universe of potential private placement participants is becoming more accessible. Suppose your client is an early-stage company looking for capital. Rather than pay commissions to an intermediary or lose control to venture capitalists, it decides to sell securities privately via the Internet. It wants to reach investors in two ways. First, it posts its offering memorandum on its Web site. Second, it wants to use a Web-based matching service that brings together accredited or sophisticated investors with companies seeking financing. At the same time, another client seeks your advice on developing this type of Web-based matching service. Both clients face significant regulatory obstacles that implicate provisions of the Securities Act of 1933 (Securities Act), the Securities Exchange Act of 1934 (Exchange Act), and the rules promulgated under both Acts. How do you advise them to ensure that their activities do not violate the federal securities laws? The task of conducting private placements over the Internet requires constant monitoring of the ever-changing federal regulations governing Internet-based securities activities. For this reason, you must be able to counsel clients based on predictions of how these regulations will be applied to evolving technology. SECURITIES ACT CONCERNS For your client who wants to post an offering memorandum on its Web site, the Securities Act presents the first hurdle. Specifically, you must carefully consider whether its posting violates the ban on general solicitations for offerings conducted in accordance with Regulation D promulgated under the Securities Act. In 1995, the SEC’s Division of Corporation Finance published an interpretive release (no. 33-7233) on the use of electronic media. Although the Division published another release this year, the guidance pertaining to private placement offering materials references the 1995 release, wherein the following scenario was described to demonstrate how an issuer could violate the general solicitation provisions governing private placements: 1. Company XYZ wants to raise $5 million by selling its common stock in a private placement pursuant to Securities Act Rule 506 of Regulation D. The Company places its offering materials on its Internet Web site, which requires various information from a person attempting to access the materials to be provided to the Company prior to displaying the offering materials. Interpretation: The placing of the offering materials on the Internet would not be consistent with the prohibition against general solicitation or advertising in Rule 502(c) of Regulation D. Based on this guidance, it is clear that postings of offering materials on issuers’ Web sites violate the general solicitation provisions governing private placements. Can issuers still use the Internet? Can issuers utilize the services of third-party networks or Web-based matching services to locate suitable investors? Generally, to participate in a private placement, investors must meet certain eligibility criteria under the definition of “accredited investor” in Regulation D. Issuers traditionally rely on commissioned broker-dealers to vet potential investors’ eligibility. Third-party matching services provide attractive alternatives to issuers seeking financing because, through the use of technology, a large investor pool becomes accessible. However, lawyers and issuers must understand that these services operate under narrowly defined parameters delineated by the SEC. Issuers must know exactly how the third party will disseminate offering materials and to whom. Following publication of the Division of Corporation Finance’s 1995 interpretive release, it issued guidance to an affiliate of a registered broker-dealer that wanted to provide this type of matching service. As described in the IPONET no-action letter (July 26, 1996), the company planned to build a base of accredited and sophisticated investors by having previously unknown customers complete questionnaires on-line. The company’s affiliated broker-dealer would review these responses and make an independent determination as to whether the potential investors were, in fact, sophisticated or accredited within the meaning of Regulation D. Once a prospective customer was deemed to be sophisticated or accredited, and had opened an account with the broker-dealer, he would be permitted to access a password-restricted Web page, which would include listings of private offerings. The Division granted relief in this instance, but underscored the importance of the following points: � all potential investors had to complete a screening questionnaire to be reviewed by the affiliated broker-dealer; � investors would only be permitted to participate in offerings made available after they were approved by the broker-dealer; and � offering materials would not be made available to others who failed to complete the questionnaire and receive approval from the affiliated broker-dealer. Satisfying these requirements is important because it serves to establish that the broker-dealer had a pre-existing, substantive relationship with the investors prior to their participation in the offering. Proving this pre-existing, substantive relationship is what protects the matching service’s activities from being deemed a general solicitation. Therefore, issuers must be cognizant of their own actions as well as the actions of third parties who participate in the offering. Specifically, an issuer that chooses to post offering materials on a third party’s site, rather than its own, will not necessarily avoid a violation of the prohibition against general solicitation if the third-party service provider does not take appropriate actions to document its pre-existing substantive relationships with its investors. EXCHANGE ACT CONCERNS Assuming you adequately address the general solicitation provisions governing private placements, either directly or via a third party, how do you advise your second client that believes it can create a database or Web-based matching service without running afoul of the broker-dealer regulations of the Exchange Act? Your first impression may be that your client merely collects names and resells them to entrepreneurs much like many mass-mailing databases. Unfortunately, your client’s activities could very easily trigger the broker-dealer registration requirements of the Exchange Act. The terms broker and dealer are defined in ��(3)(a)(4) and (3)(a)(5) of the Exchange Act. A broker is “any person engaged in the business of effecting transactions in securities for the account of others, but does not include a bank.” A dealer is “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise, but does not include a bank, or any person insofar as he buys or sells securities for his own account, either individually or in some fiduciary capacity, but not as a part of a regular business.” The staff of the SEC broadly interprets the definitions of broker and dealer. The staff also views the “business of effecting transactions in securities” expansively. Earlier guidance includes, but is not limited to, matching service no-action responses to Technology Capital Network, Inc. (June 5, 1992), Capital Resources Network (April 23, 1993), Texas Capital Network, Inc. (Feb. 23, 1994), and Michigan Growth Capital Symposium (May 4, 1995). These applicants sought no-action relief for their participation in capital-matching activities. In each instance the staff of either the Division of Corporation Finance or the Division of Market Regulation granted relief, but premised its relief on very specific facts. For example, in Technology Capital Networks, the staff of the Division of Market Regulation emphasized that it was granting relief based on the representations that: � none of the company’s employees would discuss any securities-related matters with entrepreneurs or investors; � the company’s employees would not handle any funds or securities; � none of the company’s employees, officers or affiliates would participate as entrepreneurs or investors in the system; � none of the company’s employees, officers or affiliates would have any financial control over the entrepreneurs or investors; and � no promotional materials would suggest that the company endorsed any of the participants. Given this guidance, one might first assume that adherence to these principles would permit investor matching services to operate without the need to register as broker-dealers. In fact, as recently as 1996 the staff provided similar advice in its Angel Capital Electronic Network(Oct. 25, 1996) letter. The Division of Market Regulation granted no-action relief to the Angel Capital Electronic Network and the universities and non-profit entities that participated in, or operated the network. Again, the staff noted that the participants would not: � provide advice about the merits of particular investments; � receive compensation, other than nominal fees to cover administrative costs (and that these fees would not be contingent on the consummation of a transaction); � participate in any negotiations between companies and investors; � directly assist listing companies; � handle funds or securities; or � hold themselves out as anything other than a matching service. Following a four-year period from the date Angel Capital received its no-action relief, some matching services have incorrectly assumed that as long as they adhered to the operating standards of the networks that previously received favorable staff responses, they too would be safe from regulatory scrutiny. This assumption first proved to be untrue when the staff revoked no-action relief granted to Dominion Resources, Inc. (March 7, 2000) and later in June and October of this year when the staff of the Division of Market Regulation denied similar requests submitted by Oil-N-Gas, Inc. and Progressive Technology, Inc., respectively. In the Oil-N-Gas, Inc. denial letter (June 8, 2000), the staff decided that a similarly structured matching service was, in fact, operating as an unregistered broker-dealer. The most valuable portion of the response is the staff’s discussion of what constitutes a broker-dealer. In addition to laying out the definition of a broker-dealer, the staff elaborates by stating that “a person effects transactions in securities if he or she participates in such transactions ‘at key points in the chain of distribution.’ ” ( Citing language from Massachusetts Financial Services, Inc. v. Securities Investor Protection Corp., 411 F.Supp. 411, 415 (D.Mass.), aff’d545 F2d 754 (1st Cir. 1976), cert. denied, 431 U.S. 904 (1977).) The staff further defines such participation as including, among other things, offering assistance in structuring securities transactions, assisting an issuer in identifying potential investors, soliciting securities transactions, and participating in order-taking or order routing. Furthermore, the staff stated that the phrase “engaged in the business” can include activities such as: � receiving transaction-based compensation; � holding oneself out as a broker, as executing trades, or as assisting others in consummating securities transactions; and � participating in the securities business regularly. Finally, the staff stated that soliciting securities transactions also indicates that the person is “engaged in the business.” ( Citing Securities and Exch. Comm’n v. Century Investment Transfer Corp., et al., Fed. Sec. L. Rep. (CCH) �93, 232 (S.D.N.Y. Oct. 5, 1971). In addition to denying relief, the staff went so far as to include an application form, in its denial letter, to register as a broker-dealer. This application was provided for the applicant’s “convenience.” The Division’s response in Progressive Technology, Inc.(Oct. 11, 2000) was similar to the response given in Oil-N-Gas, Inc. Progressive Technology, Inc. planned to provide a Web-based platform for companies seeking financing to reach potential investors. The company planned to have investors complete an on-line questionnaire in which they would self-certify that they were “accredited” as defined in Regulation D. The apparent deficiency was that these on-line questionnaires would not be reviewed by a registered broker-dealer. In fact, no registered broker-dealer was mentioned as having any connection to Progressive Technology, Inc. The Division’s reasons for denying relief in this case were strikingly similar to its reasons for denying relief to Oil-N-Gas, Inc. Practitioners and issuers should understand from these denials that the staff will consider all activities leading toward the consummation of a securities transactions as, most likely, requiring broker-dealer registration. The staff has clearly stated its current views regarding broker-dealer registration in these letters. Equally clear is the assumption that your client will want to avoid the costs and regulation that result from becoming a registered broker-dealer. In light of the denials in Oil-N-Gas, Inc. and Progressive Technology, Inc., many seek concrete guidance on when matching services will or will not be required to register as broker-dealers. The industry anticipates that further guidance from the staff will be forthcoming. Until then, caution is warranted. CONCLUSION Many optimists see great potential for conducting private offerings over the Internet. Many pessimists, on the other hand, believe regulation of Internet-based activities is progressing in the wrong direction. The most realistic view probably lies somewhere between these opinions. It does seem that regulation of the Internet is becoming more, rather than less, restrictive. The regulators claim this is simply because they are becoming more knowledgeable about unregistered Internet activities and less convinced that their actions will stifle technological development. As we await interpretive guidance from the SEC, the best advice is to proceed cautiously, and apply the broadest possible definitions, to your client’s business plans. Rubi Finkelstein is a partner in the company practice group of Orrick, Herrington & Sutcliffe LLPin New York. David J. Sparks is an associate in the firm’s market regulation practice group in San Francisco.

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