Roberto J. Devoto

The Internet promises to revolutionize the business world by allowing businesses to reach the customer directly and to transact business entirely within cyberspace. This method of interfacing with the customer will result in tremendous distribution cost-savings and improved customer relationships due to rapid and ongoing interactive customer feedback. These advantages will potentially make the Internet the distribution channel of choice for most businesses. As the Internet becomes more accessible and consumer confidence in it grows, the mandate to leverage it becomes more compelling due to the increasing size of the internet-connected customer market.

While the nature of the internet promises significant business advantages, it also creates significant legal challenges, particularly in the securities market. Offering securities over the Internet presents a unique challenge to securities regulation because of the ability of the offer to reach a global audience and to indiscriminately cross jurisdictional lines. This is a challenge to the US regulatory system’s frequent imposition of limitations on the scope of any offering that wishes to avoid costly US registration requirements.

The US regulatory system imposes on an issuer significant disclosure burdens prior to allowing any public offering of securities. These disclosures are made through a registration process and serve as a prophylactic measure to protect investors from securities fraud. Due to the high costs of the registration process, the SEC has allowed certain offerings to be exempt if the offering is restricted to a select, targeted group of people which is believed to not need as much disclosure protection. ¹ The SEC has also placed offering limitations on foreign and domestic issuers who wish to avoid the US regulatory system through entirely offshore offerings. ² These restrictions attempt to limit the offerees based on geography and/or offeree characteristics and represent a compromise between efficiently facilitating the acquisition of capital and protecting investors from securities fraud.

This paper will explore the impact of the Internet on the securities regulatory scheme of the US with respect to jurisdiction and solicitation limitations. ³ Part I will present a possible future in which the internet can facilitate the elimination of jurisdiction and solicitation limitations through adoption of investor and issuer choice of jurisdiction per Choi and Guzman’s 1996 article. ⁴ Part II explores the US regulatory scheme with respect to jurisdiction and solicitation if the Internet were treated like traditional media. Part III explores the incremental, conservative, accommodations that the SEC and States have made for the Internet medium, and finally, Part IV briefly discusses the implications of these accommodations with respect to the traditional regulatory structure.

The Internet’s ability to effortlessly cross jurisdictional and geographical boundaries in combination with its desirability as a tool to dramatically decrease the cost of acquisition of capital adds extra force to Guzma’s and Choi’s argument that an issuer should be allowed to choose the regulatory scheme under which it offers its securities. As the offering and trading of securities on the Internet becomes more pervasive, the jurisdictional complexity of regulation increases as differing countries may all have equal interests in an offering that is made available via the Internet to its citizens. Given competing extraterritorial jurisdictional claims, whose regulatory scheme should the issuer follow? Perhaps the best answer to this question is to sidestep the jurisdictional problems by allowing the issuer to choose the regulatory system under which the securities are offered or traded. ⁵ Such a choice, however, is only allowed if the investors are protected by enough disclosure to allow them to understand and anticipate the legal regime that will apply to them when they invest in the given securities offered by the issuer. A prominent disclaimer on the first page of an Internet securities offering web site with links to government-sponsored regulatory sites and supplemental information on the regulatory regime as needed may suffice. Such a disclaimer to assert or, similarly, to remove the securities from the extraterritorial jurisdictional reach of a regulatory system is rather similar to the disclaimer that the SEC allows foreign issuers to use to remove their Internet securities offerings from US regulation. ⁶

Aside from sidestepping the jurisdictional dilemma posed by the Internet, the proposal to allow issuer and investor choice of jurisdiction must also conform with the goals the securities regulatory regime should seek to achieve. Extraterritoriality of US regulations, applied through tests based on conduct or effect, has traditionally been justified as a means to protect US investors and the integrity of US markets. ⁷ However, as Guzma and Choi convincingly argue, extraterritoriality is neither necessary nor effective in accomplishing these goals.

The costs of extraterritoriality are many. For example, regulations that impose extra costs on overseas transactions by forcing participants to accept American laws may result in foreign issuers simply restricting their offerings to investors who are not residents of the United States. This may have a direct and harmful impact on capital mobility by limiting the ability of American investors to purchase securities issued abroad. This reduction in mobility is harmful to the issuer as a smaller pool of potential investors makes selling the offering more difficult. Furthermore, a smaller market implies that for any given price the demand for the securities will be lower, and therefore, the price of the securities will necessarily fall when trying to sell a particular volume. American investors lose because they have less options in which to invest; the issuer loses due to a decrease in the liquidity of its securities; and overall global welfare decreases due to this lack of liquidity driving down the price of securities and making it unprofitable for some positive net present value projects to be funded in this manner.

Limited extraterritorial application of US law bypasses these costs and, therefore, translates into greater choice for investors and issuers. This greater capital mobility will lead to greater competition between regulatory regimes to attract both issuers and investors. In selecting a jurisdiction, issuers will take into account the regulatory protections, their associated costs (e.g. disclosure costs), and the price investors will be willing to pay for the securities. Investors, in turn, will pay based on the level of protection the jurisdiction’s regulatory scheme will provide. A jurisdiction which demands less disclosure or penalizes fraud less severely will be less expensive for the issuer, but securities issued under such a regime will command lower prices due to the lower investor protection.

The Internet further enhances Choi’s and Guzman’s arguments in favor of issuer choice of jurisdiction by speeding up the globalization of the securities market, further removing the traditional ties between jurisdiction and geography, and augmenting the costs to the US of assertion of extraterritorial jurisdiction in terms of regulation and enforcement. The Internet has brought to the forefront the limitations of the current US securities regulatory system, and perhaps a radical change, such as that suggested by Guzman and Choi, is in order.

The traditional regulatory regime of the US is ill-equipped to deal with the complexities of the Internet medium with respect to the offering of securities over the Internet. The emphasis of the current regime is on the audience exposed to a given securities offering, not just on the individuals that are actually allowed to purchase the securities offered. As discussed below, exemptions to the registration requirement for securities offerings and assertion of US regulatory law jurisdiction over offshore offerings depend significantly on the audience exposed to the offering. Indiscriminate offerings over the Internet with no restrictions on target audiences (i.e. the audience that has access to the actual web-site containing the offer) will typically require registration as such an offering will be considered public and will preclude most exemptions. ⁸ Furthermore, any foreign issuer indiscriminately offering securities over the Internet will lose the Reg. S safe harbor and will face the uncertainty of possible violation of US registration requirements. To avoid this, the issuer must target a specified audience when offering its securities. The Internet medium, however, is currently ill-equipped to target specific audiences with the rigor necessitated by the traditional securities regulatory regime. Technological methods that provide the user information necessary for targeting may be possible in the future (e.g. P3P); however, any such technological mechanism may be easily bypassed by the user because of his control over the validity of any personal information he inputs. ⁹ Effective enforcement of the requirement that only a specified target audience be exposed to the web-site offer will be at best highly impractical and at worst impossible. ¹⁰ The following discussion will explore the impact of these limitations on the traditional regulatory regime with respect to its treatment of solicitation and jurisdiction. The discussion will treat the Internet in the same manner as traditional media.

Section 5 is the cornerstone of the Securities Act, covering all offers and sales of securities. Under Section 5, an issuer must file a registration statement and must distribute a prospectus, under certain conditions, to investors prior to any sale of securities. Most non-issuer sales, however, are exempt from Section 5 under Section 4(1) of the Act. The jurisdictional reach of section 5 has been defined broadly to cover all offers and sales of securities that make use of "any means or instruments of transportation or communication in interstate commerce." The definition of interstate commerce, as provided in Section 2(7) of the Act, includes transportation or communication "relating thereto among the several states" and "between any foreign country and any State, Territory, or the District of Columbia." Courts have defined this to include not just any transaction between states or between a foreign country and a state but also any transactions which involve the use of any "means" of interstate commerce (e.g. phonelines, mail) in any part of the transaction. This broad definition gives Section 5 a very expansive jurisdictional reach.

Complying with the disclosure requirements of registration is expensive. ¹¹ Issuers seeking to avoid the expense may do so through various exemptions. Exemptions include a 3a(11) intrastate exemption, a 4(2) private placement exemption, and Reg. D Rule 504, 505 and 506 exemptions. In addition, offshore offerings by domestic or foreign issuers may be exempt from registration if they comply with Reg. S. The Reg. D Rule 504 exemption is the only exemption that does not require the offer to be targeted at a specified audience. The Rule 504 exemption, however, is limited to relatively small offerings with offering prices of $1M or less and is not available to reporting companies.

A company which seeks to avoid registration via a 3a(11) exemption must meet various requirements. The issuer must be resident within the state, a predominant amount of the proceeds of the offering must stay in the state, and the issuer must conduct a predominant amount of its business within the state. Furthermore, all of the offerees and purchasers must be residents in the state. This last requirement is problematic for Internet offerings. As discussed above, an Internet offering is ill-equipped to efficiently target in-state residents. Out-of-state residents will inevitably be exposed to the offer. According to Section 2(3) of the Securities Act, an offer is "every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value." If the SEC uses the same broad interpretation of this definition that it applies to traditional media, an Internet offering will necessarily preclude the intrastate exemption due to exposure of the offer to non-residents, thereby making them offerees.

A similar dilemma faces the issuer who wishes to obtain a 4(2) private placement exemption or a Rule 505 or 506 exemption. The 4(2) private placement exemption requires that the offerees be able "fend for themselves." ¹² This has been interpreted to mean that they must be sophisticated and have access to or issuer disclosure of information that is equivalent to that presented in a registration statement. ¹³ Rule 505 and 506 exemptions also depend on the sophistication of offerees. ¹⁴ An issuer may not allow more than 35 unsophisticated investors to be offerees in order to qualify for the exemptions. ¹⁵ Furthermore, Rule 505 and 506 also have a rule against general solicitation. This has been interpreted to mean that the issuer may only solicit potential investors if the investors have a preexisting relationship with the issuer or selling agent or general partner. ¹⁶ Without special accommodation, an Internet offering can never be exempt under 4(2), Rule 505, or Rule 506 as such an offering will not be able to distinguish between sophisticated and unsophisticated offerees. However, since Rules 505 and 506 require a preexisting relationship, it is possible to have an exempt "internet offering" by making the web site inaccessible unless a password is typed in. The issuer will use its preexisting relationship with the offeree in order to give the investor the password beforehand. This "Internet offer," however, is not a true Internet offer in the sense that it does not leverage the Internet’s ability to identify heretofore unknown investors. The identification was done beforehand, and the Internet was simply used as a convenient disclosure medium.

Offshore securities offers made via the Internet also risk falling within Section 5’s jurisdictional reach due to the Internet’s inability to effectively target prospective offerees. Regulation S provides a safe harbor for domestic and foreign issuer offshore distributions of securities. Issuers that satisfy the Regulation S requirements for a given offering need not worry about registering the issue as it is deemed to be outside the US and not subject to Section 5. The requirements for exemption under Regulation S are presented in Rule 903(a) and (b). The goal of these requirements is to prevent securities issued offshore from "flowing back" to the US market. Rule 903(a) lists two basic requirements that must be met by all issuers, and Rule 903(b) imposes additional requirements depending on the likelihood of the securities to flow back. Rule 903(a) requires that the offering be an "offshore transaction" and that no "directed selling efforts" occur in the US. In order for an offer to be an "offshore transaction," no offers may be made to persons in the US. Furthermore, the buyer must be offshore at the time of the purchase, OR the sale must be made on the floor of an established foreign securities exchange, OR for purposes of the resale safe harbor, the sale must be made through the facilities of a designated offshore securities market, and the transaction must not pre-arranged with a buyer in the US. The requirement that no offers be made to persons in the US is similar to the 3a(11) requirement that no offers be made to non-residents of the state and, therefore, poses the exact same problem with respect to Internet offerings. If no accommodation is made for the Internet medium, an Internet offering will necessarily preclude the Regulation S safe harbor due to exposure of the offer to US residents, thereby making them offerees.

In sum, the traditional US securities regulatory regime is ill-equipped to deal with the Internet without special accommodation. Absent such accommodation, issuers that wish to avoid costly registration will hesitate to use the internet medium to raise capital because of the fear that the solicitation limitations of their exemptions will be violated. Furthermore, foreign issuers offering securities over the internet will face the uncertainty of violating Section 5 registration requirements due to their inability to satisfy the solicitation limitations of the Reg. S safe harbor.

The SEC is beginning to take steps to accommodate the Internet medium with respect to the regulatory limitations on solicitation and jurisdiction. Consistent with its cautious and incremental approach to regulatory reform, the SEC has decided to address the regulation of offshore internet offerings first, due to the gravity of the problem of conflicts of jurisdiction with foreign countries. For example, if an English company wants to offer and sell its securities using the Internet, must it register its securities in the United States, even if the company does not intend to offer its securities outside England? In practical terms, requiring such a company to register its securities might place a significant burden on its capital-raising efforts and might be difficult for the SEC to enforce (especially without retaliation from other countries). Nevertheless, under the traditional regulatory regime, such a company will not be able to avail itself of the Reg. S safe harbor as discussed in Part II and will therefore face the uncertainty of being subject to Section 5 registration.

The SEC responded to this issue on March 23, 1998 in Interpretative Release No. 33-7516. In this release, the SEC states that an offshore internet offering will not be considered to be "targeted at the United States" if the offeror takes adequate measures to prevent U.S. persons from participating in the offshore Internet offer. What constitutes adequate measures "depends on the facts and circumstances of any particular situation." More specifically, the SEC states that it would not consider an offshore Internet offer made by a non-US offeror as targeted at the United States if it meets two requirements: (1) the Web site includes a prominent disclaimer saying that the offer is directed only to countries other than the United States, and (2) the Web site offeror implements procedures to reasonably ensure no securities actually get sold to US persons in the offshore offering. ¹⁷ The above measures allow a foreign issuer to bypass the problem of the no-US-resident-offeree requirement of Reg. S, despite the exposure of the offer to US residents. A foreign issuer making an unregistered offshore Internet offer can thus avoid Section 5 registration by implementing the above measures in conjunction with the other Reg. S requirements.

The SEC takes a more restrictive approach with respect to domestic issuers making offshore offerings. ¹⁸ In addition to the two requirements mentioned above, a US issuer must implement password-type procedures that are reasonably designed to ensure that only non-US persons can obtain access to the offer. This requires that persons demonstrate to the issuer or to an intermediary that they are not US residents before obtaining the password giving them access to the Web site offer. As discussed previously, password protection is a valid way to restrict exposure of an internet offer to a given audience; however, this "Internet offer" is not a true Internet offer in that the Internet will only be used as a convenient disclosure mechanism and not for solicitation purposes. The issuer is forced to solicit investors via traditional media. If the issuer tries to solicit interest via the Internet in an attempt to get people to call for the password to the site, the SEC, absent acceptance of a "test the waters" Rule 135d proposal, will consider such a solicitation of interest an untargeted "offer" under Section 2(3) that violates the Reg S safe harbor.

In sum, the SEC allows foreign issuers to make offshore internet offerings provided the offer has the appropriate disclaimers and proper precautions are taken to insure that no securities are actually sold to US residents. The SEC, however, has not agreed to the same accommodation for domestic issuers. By requiring password protection, it has effectively precluded domestic issuers from soliciting investors via the Internet, demoting the Internet medium to a simple disclosure mechanism.

The States have also begun to accommodate the Internet medium in their respective securities regulatory systems. Since an Internet offering is accessible to any person in any of the States, many states have concluded that an offering of securities via the Internet constitutes an offer of securities within their borders and therefore is subject to the states’ registration requirements, unless an exemption or exclusion from registration is available. ¹⁹ Pennsylvania was the first state to implement an exemption from registration for offerings made on the Internet. In August 1995, Pensylvania issued a discretionary order that exempts the offer, but not the sale, of securities by an issuer that does not intend to offer and sell securities in Pennsylvania. ²⁰ The exemption is self-executing provided that the issuer meets three conditions: (1) the issuer indicates, through either direct or indirect language, that no offer or sale of the securities is intended to take place in Pennsylvania; (2) the issuer, or anyone on behalf of the issuer, does not direct the offering of securities to any person in Pennsylvania; and (3) no sales of an issuer’s securities are made in Pennsylvania as a result of the Internet offer.

Following Pennsylvania’s adoption of this order, the North American Securities Adminstrators Association, Inc (NASAA) adopted a resolution that encourages all "state securities regulators to develop a uniform policy concerning offers of securities on the Internet that is consistent with the goals of investor protection and access to capital markets." ²¹ The resolution provides a framework for an exemption similar to that set forth by the Pennsylvania order. It, however, adds two extra conditions: (1) No sales of the securities may be made in any state until the offering has been registered and declared effective and the final prospectus has been delivered to the investor prior to such sale; OR (2) the sales are exempt from registration. ²² At least twenty-two states have adopted Internet offering exemptions using this framework including Alaska, Arkansas, Connecticut, Idaho, Indiana, Iowa, Kansas, Maryland, Michigan, Mississippi, Montana, Nebraska, North Dakota, Pennsylvania, South Carolina, South Dakota, Texas, Utah, Vermont, Washington, West Virginia and Wisconsin. ²³

The measures taken by the States and the SEC to accommodate the Internet are similar in that they change the focus of their respective regulatory regimes from the "offer" to the actual "sale" of the securities. Since the Internet is unable to effectively aim an offer at a specific target audience, this shift is essential in making the Internet a viable communication medium for raising capital as it gives communications with "sloppy aim" more latitude. Through the use of disclaimers and additional sales precautions, both the SEC and the States are beginning to allow unregistered offerings on the Internet that otherwise would have violated their traditional regulatory regimes due to exposure to a restricted audience. The SEC could conceivably use this same approach to allow issuers to offer unregistered securities on the Internet under one of the exemptions discussed in Part II. However, the reluctance of the SEC to allow domestic issuers the same exemption as foreign issuers with respect to offshore offerings suggests that the SEC will be extremely cautious in embracing unregistered Internet offerings. The SEC’s caution is well-founded as the Internet, by its nature, raises the stakes of the game. The promise of a tremendous increase in access to capital markets must be tempered by the promise of a corresponding increase in potential securities fraud. ²⁴

The Internet poses a unique challenge to securities regulation because of its ability to reach a global audience and its ability to effortlessly cross jurisdictional lines. The jurisdictional reach and the imposition of registration under US regulatory law depends significantly on the audience targeted by a given offering. The Internet’s inability to target audiences effectively has created difficulties with respect to assertion of jurisdiction and imposition of US registration requirements on any issuer seeking to offer securities on the Internet. Choi and Guzman present an argument for issuer and investor choice of jurisdiction that should bypass the majority of these difficulties. The radical nature of their solution, however, makes it unlikely to be implemented.

The traditional US securities regulatory regime is gradually changing to accommodate the Internet medium. Currently, however, an issuer who wishes to offer securities via the Internet must still deal with regulations that impose jurisdiction and solicitation requirements that effectively preclude the issuer from availing itself of the majority of exemptions to US registration. The States have begun to address the problems of securities offerings via the Internet by allowing unregistered offerings with disclaimers and adequate sales precautions. The SEC has taken a similar approach for offshore offerings by foreign issuers under Reg S but is reluctant to make similar accommodations for domestic issuers or for other registration exemptions/safe harbors. Nevertheless, the path to accommodation of the Internet is clear – regulatory systems must shift their focus from "offers" to "sales" of securities in order to fully embrace the Internet medium. The price of such accommodation, however, may be too high as the advantages of increased access to capital markets that the Internet may provide must be considered in light of the disadvantages of the corresponding increased facility to commit securities fraud.

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