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SEC Issues Guidance on the Use of Electronic Media by Issuers
Gerard S. DiFiore, Michael B. Pollack and Matthew G. Schwartz*

Introduction
Widespread and rapid information dissemination has led to nearly eleven million investors in U.S. securities markets using on-line brokerage companies. The Internet, electronic mail, and other electronic media are being used to solicit prospective investors and serve this ever-increasing segment of the investing community. Similarly, closely held and publicly traded companies alike are using the Internet to provide the public with educational materials and information about their products and services; and publicly traded companies are using the Internet to provide the investing public with shareholder services and information regarding their securities.

While such developments have provided individual investors with greater access to information, the dangers involved with inadequate and often inaccurate dissemination of information over the Internet has created a cause for concern by the U.S. Securities and Exchange Commission ("SEC" or the "Commission"), which published interpretive guidance and requested public comment on the issues.

As the Commission is providing interpretations and proposing rulemaking to curb abuses in connection with public and private offerings over the Internet, management of public companies and companies considering a public or private offering should be aware of several common pitfalls that may be encountered simply by communicating with potential investors on-line. For example, imagine the issuer, preparing for its first registered offering and spending thousands of dollars on its Website only to find that public access to the site prior to and during the registration process may have caused the issuer to engage in "gun jumping" in violation of the Securities Act of 1933 ("Securities Act"). Or, consider members of management in a privately held company, seeking to raise additional capital and eager to educate investors about their company and its products. To this end, management, in connection with a private offering, provides public access to their Website only to find that they have conducted a "general solicitation" within the meaning of the Securities Act, and as such, have lost any available private offering exemption. Both of these violations of the securities laws, though inadvertent, are extremely costly.

Even more startling, consider the third-party, non-registered service provider expanding public access to a company's Website in preparation for an upcoming public offering. If that third party is found to have solicited public interest in the IPO, he has effectively violated Section 15 of the Securities Exchange Act of 1934 by conducting a transaction as an un-registered broker-dealer.

These and numerous other issues facing companies who seek investors using the Internet prompted the SEC to release its recent interpretation on the use of electronic media. The guidelines have been designed to encourage the issuer to be "web friendly" in the quest to communicate and raise capital on the Internet, while at the same time maintaining compliance with the federal securities laws.

Electronic Delivery of Information to Investors
Companies engaged in the issuance of stock ("Issuers") and market intermediaries ("Intermediaries") must analyze whether information electronically provided to investors complies with federal securities laws. The interpretative guidance provided by the SEC attempts to clarify regulatory issues relating to electronic delivery of information:

  • An investor can consent to electronic delivery of documents by telephone, provided consent is procured in a manner that assures the investor's identity and a record of that consent is retained.
  • An investor may give global consent to electronic delivery of all documents, provided that consent is informed. To be informed, investors must truly understand that they are providing consent to delivery of all of Issuers' documents via modes of electronic communication. Consent cannot be established by the mere inclusion of a clause requiring global consent as a condition to opening a brokerage account. The investor must also be advised of his right to revoke global consent and to receive hard copies of all documents. With adequate disclosure at inception, an Intermediary may require revocation of global consent on an "all-or-nothing" basis. Finally, to constitute informed consent, global consent must identify the types of electronic media authorized by the investor.
  • Electronic information may be sent in Portable Document Format ("PDF"), provided it does not prevent investor access to the information, and provided Issuers and Intermediaries: (i) inform investors, at the time they obtain consent for electronic delivery, of the software requirements to download PDF; and (ii) provide investors, at no cost, with the necessary software and technical assistance to utilize PDF.
  • If an Issuer's prospectus is delivered on its Website, the information contained on that Website will not be deemed part of the prospectus, unless the Issuer or an Intermediary deliberately linked the prospectus to the Website's content.

Website Content - Issues Related to Hyperlinked Information
The SEC's guiding principle is that the federal securities laws apply equally to Website content as to all other statements made by or attributable to Issuers, including municipal securities Issuers. Issuers must consider the application of Section 5 of the Securities Act to all communications with the public. Issuers must be vigilant to protect against misleading the public, and, while in registration, must undertake heightened scrutiny.

Statements by Issuers that are reasonably expected to reach investors, including those made on the Internet, must be accurate. What about hyperlinks from Issuer's Website to third-party information and reports? Third-party information is attributable to an Issuer, if the Issuer was involved in the preparation of the information (the "Entanglement Theory"), or explicitly or implicitly endorsed or approved the information after its publication by a third party (the "Adoption Theory"). Liability under the Entanglement Theory depends upon the Issuer's level of pre-publication involvement in the preparation of the third-party information. Liability under the Adoption Theory depends upon whether, after its publication, an Issuer, explicitly or implicitly, endorses or approves the third-party information. In determining whether an Issuer adopted information on a third-party Website to which the Issuer has established a hyperlink, the SEC will consider all of the circumstances surrounding the hyperlink, including:

  • Context of the hyperlink - What does the Issuer say about the hyperlink? What is implied by the context in which the Issuer places the hyperlink? Does the Issuer explicitly endorse the hyperlink information? The context may imply that the hyperlink information is attributable to the Issuer whether or not the Issuer comments on the hyperlink or its content.
  • Context within a required filing - When an Issuer embeds a hyperlink within a document to be filed with the SEC or delivered to investors, the Issuer is deemed to be adopting the hyperlink information.
  • Risk of confusion - Has the Issuer protected against investor confusion about the source of the hyperlinked information? Does the Issuer use an intermediate screen to make sure the visitor knows that he is leaving the Issuer's Website and that the upcoming information is not provided by the Issuer?

To avoid adoption, access to hyperlinked information should be preceded or accompanied by a clear and prominent statement from the Issuer that it is not responsible for, nor does it endorse, the information. The Issuer should not frame the hyperlink or present the hyperlinked information side-by-side with the Issuer's information, as this may increase the risk of investor confusion.

The SEC noted the following general principles in evaluating whether hyperlinked information has been "adopted":

  • The express endorsement of hyperlinked information in support of a statement by an Issuer may indicate adoption. An example of such an endorsement provided by the SEC is a hyperlink preceded by language that the hyperlink "contains the best description of our business that is currently available."
  • Disclaimers by themselves do not necessarily avoid adoption. The use of an intermediate screen indicating that the user has left the Issuer's Website is helpful.
  • Creating a "deep link", a link directly to a subsection of a third-party Website, may constitute adoption of that information. A link to the first page of a third party Website is less likely to indicate adoption.
  • "Framing" or putting the border of an Issuer's Website around information from a third party Website may indicate adoption.
  • Issuers should not enable or disable hyperlinks or create differences in size or color of a hyperlink based on whether the information is more or less favorable to the Issuer.

Including Information on a Website While in Registration
Issuers in registration must consider the application of Section 5 of the Securities Act to all of its communications with the public. Therefore, Issuers must avoid inadvertently providing information to the public, whether directly on their Website or by a hyperlink to a third-party Website, which might meet the statutory definition of an "offer" under the Securities Act. Why? Because an "offer" may only be made by the use of a prospectus meeting the specific item by item disclosure requirements of the Securities Act. All other offers are illegal and violate Section 5.

Any information that the Issuer intends to include in the prospectus by a hyperlink in the prospectus to the information, must be filed as part of the registration statement and such hyperlinked information is subject to Section 11 liability. On the other hand, hyperlinking from a non-prospectus source to the prospectus would not result in the non-prospectus document being considered part of the prospectus. The other document may, however, be considered to be additional offering material subject to liability under Section 12.

A preliminary prospectus may be posted on the Issuer's Website. Posting of a prospectus does not act to make all other information on the Website part of the prospectus, unless the Issuer affirmatively makes such information part of the prospectus.

Therefore, Issuers are well advised to carefully scrub their Websites (1) to remove any reference to information that could be considered an impermissible offer and (2) to rectify any Website information that is inconsistent in any way with the Issuer's disclosures in its prospectus.

Other External Issuer Communications While in Registration
Issuers in registration should only provide the public with business and financial information that they have traditionally provided in the ordinary course of business, which may include the following:

  • Advertisements concerning the Issuer's products and services;
  • Exchange Act reports;
  • Proxy statements, annual reports to security holders and dividend notices;
  • Press announcements concerning business and financial developments;
  • Answers to unsolicited telephone inquiries concerning business matters;
  • Security holders' meetings and responses to security holder inquiries relating to those matters; and
  • Statements falling within an available Securities Act safe harbor.

This advice should also be followed by non-public Issuers considering an initial public offering. If a first-time Issuer contemporaneously establishes a Website, the Issuer needs to apply this guidance much more strictly. When evaluating Website content, the Issuer may not have established a history of business communications in the ordinary course with the market. Therefore, investors may be unable to evaluate the Issuer's communications in an appropriate context.

Online Public Offerings
The Commission reinforced the application of the principles basic to on-line offerings, and provided guidance to the participant to engage in electronic commerce within the parameters of the federal securities laws. In particular, the Commission focused on the dissemination of information to investors during the registration process.

To prevent the unwary issuer, underwriter or broker-dealer from falling into a trap, and finding itself in violation of the Securities Act, the SEC reasserted two guidelines to follow, both of which are derived from the old paper-based offering process:

  • First, offering participants are prohibited from selling, or entering into a contract to sell a security, prior to the effective date of the registration statement (and therefore no offers to buy may be accepted and no part of the purchase price can be accepted by or on behalf of the Issuer until effectiveness); and
  • Second, written offers must be made only by means of a prospectus, oral offers may be made only following commencement of the "waiting period" (which begins when the registration statement is filed). Indeed, before a registration statement is filed, all offers (including offers made by e-mail), and offers transmitted by radio or television, are strictly prohibited. Following the effective date of the registration statement, however, participants may disseminate sales literature and/or other writings provided that these materials are accompanied by or preceded by a final prospectus.

Online Private Offerings
The plethora of newly emerging high-tech or "Web friendly" companies has spawned a resurgence of private offerings. Although many of these companies understandably choose to raise their early rounds of capital privately (avoiding the costs associated with a registered offering), the use of the Internet to facilitate a private offering will likely be fatal to the Issuer's private offering exemption. Offerings that are not private are not exempt from registration. The SEC's rules strictly prohibit the Issuer and persons acting on the Issuer's behalf from engaging in any form of general solicitation or advertising in connection with a private offering.

How can one avoid loosing the exemption? The general view of the Commission is that a private offering may be conducted on-line if a registered broker-dealer, as agent for the Issuer, establishes that a substantive, pre-existing relationship existed with each investor to whom an offer was communicated, and confirms that each investor is accredited and sophisticated within the meaning of Regulation D under the Securities Act.

The SEC views the posting of private placement documents on a Website, absent procedures that strictly limit document access solely to accredited investors, as a general solicitation that spoils the availability of the private offering exemption.

Recently, however, third-party service providers who are neither registered broker-dealers nor affiliated with registered broker-dealers, have established Websites that invite potential investors to become "self-accredited" as a prelude to participation in a later offering. In particular, these sites often permitted investors to attain accreditation simply by "checking a box" on a standardized form, rather than completing an extensive questionnaire which would provide information needed to form a reasonable belief as to the investor's accredited status or level of sophistication. The SEC cautioned that Website operators that allow "self "accreditation may be engaged in a general solicitation.

Finally, the Commission cautioned that in addition to the general solicitation issues noted above, website operators must determine whether their activities trigger broker-dealer registration, inasmuch as such activities may constitute "effecting transactions in securities or attempting to induce the purchase or sale of securities". The release discussed certain misconceptions the market may have made regarding recent no-action positions in this area and encouraged Issuers and third-party providers to seek staff advice to resolve issues raised by non traditional activities.

For questions, comments or additional information, please contact Gerard DiFiore directly at gdifiore@reedsmith.com. Or, you may obtain biographical information at www.reedsmith.com/attorneys/alpha/d/difioreg.html.

*Gerard S. DiFiore and Michael B. Pollack are partners in the Corporate and Securities Group at the law firm of Reed Smith Shaw & McClay LLP. Matthew G. Schwartz is an associate in the Corporate and Securities Group.

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