Private Offerings

• What is an online private offering?
• Why is it difficult to imagine a private offering on the Web?

• How can a company conduct a private offering?
• How can a company conduct a private offering under Rule 505?
• How can a company conduct a private offering under Rule 506?
• What is "general solicitation or advertising"?
• Who is an "accredited investor"?
• Who is a "sophisticated investor"?

• How can a company conduct an online private offering?
• Has the SEC cleared any online private offering "Web fronts"?
• Is a service provider that qualifies investors for private offerings required to register as a broker?
• What is a "pre-existing substantive relationship"?
• Can a company or service provider establish substantive relationships online with investors?
• What is "self-accreditation"?
• Can non-brokers establish substantive relationships with investors online?
• What if a non-broker operates a Web site that establishes substantive relationships with investors online?
• Does a company or its broker need to show that it had pre-existing substantive relationships with investors to prove that it did not generally solicit?
• How can companies or brokers establish pre-existing substantive relationships with accredited and sophisticated investors online?
• What information should an online questionnaire elicit from an investor before it can participate in a private offering?
• How can brokers solicit a significant number of offerees for a private placement online?
• What are the differences between soliciting investors for a public company's private offering and a private mutual or hedge fund?
• Can a company or broker accept electronic indications of interest in a private offering?
• Should private offering Web fronts register as investment advisers?
• Can a Web front operator be liable as an issuer simply by posting private placement memorandums on its Web site?
• How does Regulation FD affect communications during a private offering?
• What do critics of the SEC's positions regarding online private offerings say?

• Do companies need to comply with state law if they conduct online private offerings under Regulation D?
• How can companies offer securities online only to California residents?
• What is a "qualified investor" under the California law that facilitates online private offerings to California residents?
• How can companies offer securities online only to New York residents?
• How can companies offer securities online only to Texas residents?
• Will a state regulate offers made on the Internet if sales are not made in the state?
• How do states regulate sales on the Internet?
• How are state regulators monitoring online offerings?

• Which companies have conducted private offerings online?
• Which brokers are qualifying investors for private offerings online?
• Which non-brokers are qualifying investors for private offerings online?

A. Understanding Online Private Offerings

What is an online private offering?

An offering conducted via the Web and/or e-mail that is exempt from U.S. registration requirements - so the offering does not have to be filed with the SEC.

Online private offerings are conducted pursuant to offering exemptions under either:

Why is it difficult to imagine a private offering on the Web?

Because its hard to keep anything "private" on the Web - since companies that conduct private offerings are not permitted to "generally solicit" investors or "generally advertise" their offerings.

This can be a tough obstacle for online private offerings - since the mere posting of information about a private offering is considered a general solicitation (without any further precautions, such as password protection). See more @ what is "general solicitation." However, the SEC has provided guidance to allow broad dissemination of private placement memorandums to investors who are pre-qualified online.

For private offerings whose state registration regulation is not preempted by federal law, most state limited offering exemptions also prohibit general solicitation and advertising. See more @ state regulation of Internet offerings.

Source: The SEC repeatedly has noted that a publicly available private offer violates the "general solicitation" prohibitions - including Section II.C.2. of Release 33-7856 (May 4, 2000) and Example 20 of Release 33-7233 (October 6, 1995).

B. How to Conduct a Private Offering

How can a company conduct a private offering?

By conducting a non-public limited offering, either under Section 4(2) or Regulation D (under either Rule 505 or Rule 506).

To ensure that an offering is "non-public" and can therefore qualify for Section 4(2) or Regulation D, a company may not engage in any "general solicitation or advertising." See more @ the meaning of general solicitation and advertising.

Note that federal preemption of the ability of states to require registration of Rule 506 offerings and "covered securities" facilitates the ability of companies to conduct online private offerings - companies only have to make simple notice and fee filings for these offerings in states in which they intend to sell. See more @ state regulation of private offerings.

Note: An offering document in a private offering is called a "private placement memorandum" or an "offering circular" - not a "prospectus." A broker who brings the issuer and buyers together in a private placement is called the "placement agent" - not an underwriter. Private offerings are conducted on a "best efforts," rather than on a "firm commitment" basis.

How can a company conduct a private offering under Rule 505?

$5 million worth of securities can be sold to an unlimited number of "accredited investors" as well as 35 other investors - audited financial statements are required if non-accredited investors are included in the offering.

Source: Rule 505(b)(2)(i) sets forth the aggregate offering price cap and Rule 505(b)(2)(ii) limits the number of buyers. Rule 502 explains when audited financials are required and defines "accredited investors" - see more @ what is an "accredited investor."

How can a company conduct a private offering under Rule 506?

An unlimited amount of securities can be sold to an unlimited number of "accredited investors" and 35 sophisticated investors - audited financial statements are required if sophisticated investors are included in the offering.

Note that federal securities law preempts the ability of states to require registration of Rule 506 offerings - this has made Rule 506 offerings more popular since the preemption was enacted by Congress in 1996.

Source: Rule 506(b)(2)(1) limits the number of buyers and Rule 502 explains when audited financials are required. States are not permitted to require registration of Rule 506 offerings under Section 18(b)(4)(D) of the Securities Act of 1933 (since Rule 506 was promulgated under Section 4(2) of the Act, which is preempted from state regulation in that provision).

What is "general solicitation or advertising"?

Any information generally available or widely distributed to promote the sale of a security.

The SEC has provided guidance as to what activities a company or its placement agent can undertake in connection with an online private offering without violating the general solicitation restrictions. See more @ conducting an online private offering.

Note that the general solicitation and advertising restrictions apply during the entire offering period.

Some commentators have expressed a desire for the SEC to eliminate the prohibition on general solicitation or advertising in private offerings for some time. See more @ criticism of the SEC's positions regarding online private offerings.

Source: "General solicitation" and "advertising" are more precisely defined in Rule 502(c) of Regulation D. The Committee on Federal Regulation of Securities of the Business Law Section of the ABA noted its position that the SEC should eliminate the general solicitation prohibition in its August 2, 2000 comment letter on Release 33-7856 (May 4, 2000).

Who is an "accredited investor"?

Investors with a net worth of $1 million - or income of $200K (or $300K for couples, if one spouse cannot meet the $200k threshold) in each of the last two years.

Source: The complete definition of "accredited investor" is in Rule 501(a) of Regulation D.

Who is a "sophisticated investor"?

An investor whom a company reasonably believes has adequate knowledge and experience in financial and business matters to evaluate its securities offered for sale.

Source: Although the term "sophisticated investor" is not specifically defined in the federal securities laws, its concept is described in Rule 506(b)(2)(ii) of Regulation D.

C. How to Conduct an Online Private Offering

How can a company conduct an online private offering?

By conducting an offering in a way so that general solicitation or advertising is not used.

This can be done in a variety of ways, such as:

Has the SEC cleared any online private offering "Web fronts"?

Not exactly. The SEC does not specifically clear Web fronts - but the SEC staff has issued several no-action letters that address facts provided by Web fronts.

Although the SEC staff has stated that other Web fronts can rely on the fact patterns in these letters to create similar Web sites without prior SEC staff clearance, the SEC staff presently is revisiting some of the issues raised in these letters - so they may not be reliable precedent at this time. See more @ controversial issues involving Web fronts.

The Web fronts that have received no-action relief are:

Is a service provider that qualifies investors for private offerings required to register as a broker?

Most likely - particularly based on the SEC's recent statements about this issue.

Service providers need to consider whether their online activities induce investors to buy or sell securities - if so, they need to register as a broker (even though the private offerings themselves are exempt from SEC registration).

To determine whether a service provider's activities require broker registration, contact the Office of Chief Counsel in the SEC's Division of Market Regulation at (202) 942-0073.

Source: Section 15 of the Securities Exchange Act of 1934 requires persons to register as a broker if they induce investors to trade. In footnotes 88-93 and related text of Release 33-7856 (May 4, 2000), the SEC strongly noted that its staff in the IPONet no-action letter (available July 26, 1996) required a broker to maintain overall supervision of a Web front's activities - otherwise, the staff would have required the Web front to register as a broker. In footnote 94 of that release, the SEC asked its Division of Market Regulation to consider whether Web front operators conducting activities similar to those conducted by the non-broker in the Lamp Technologies no-action letters (available May 29, 1998 and May 6, 1997) would have to register as a broker in a non-private hedge fund context.

What is a "pre-existing substantive relationship"?

A relationship that exists between:

What is "self-accreditation"?

An investor fills out a questionnaire indicating that it's an "accredited" or "sophisticated" investor - and the Web front does not conduct any further due diligence or verify any of the details in the questionnaire.

The SEC does not believe that self-accreditation can be the basis for a reasonable belief that an investor is eligible to participate in a private offering - and the SEC believes that the use of self-accreditation calls into question whether general solicitation is truly not involved in the offering.

Source: In footnote 85 and related text of Release 33-7856 (May 4, 2000), the SEC strongly noted that self-accreditation can prevent reliance on an exemption from registration.

Can non-brokers establish substantive relationships with investors online?

Probably not - historically the SEC only has allowed brokers to make the determination of whether an investor is eligible as an "accredited" or "sophisticated" investor (sophistication being relevant if Rule 506 is the safe harbor relied upon).

Brokers are preferred to make these determinations because they have fiduciary duties and are required by SEC rules to deal fairly and make suitable recommendations to investors - these obligations arguably provide a layer of investor protection that non-brokers don't provide.

The SEC has noted that there may be circumstances under which non-brokers could establish pre-existing substantive relationships - but in the absence of further guidance from the SEC as to what those circumstances are, companies should consult the Office of Chief Counsel in the SEC's Division of Market Regulation at (202) 942-0073 and the Office of Chief Counsel in the SEC's Division of Corporation Finance at (202) 942-2900 before they use a non-broker that operates a Web front.

Some commentators have asked the SEC to clarify that "pre-existing substantive relationships" can be created by any party, including non-brokers - either without registering as a broker or under a new limited broker registration scheme to reflect this new type of market participant.

Source: The SEC left the door open for non-brokers to argue that they can operate Web fronts in Section II.C.2. of Release 33-7856 (May 4, 2000) - but also included strong language reducing the likelihood that its staff will provide no-action relief to non-brokers. In footnote 88 of this release, the SEC clarified that the Lamp Technologies I no-action letter (May 29, 1997) should not be interpreted as allowing non-broker service providers to qualify investors - rather, it should be interpreted solely in the context of private hedge funds offerings (probably because there is no transaction-based compensation involved). The SEC asked the Division of Market Regulation to consider whether Web site operators similar to the one in Lamp Technologies would be required to register as a broker in footnote 94 of Release 33-7856 (May 4, 2000). Also notable is that the Division of Market Regulation recently overturned its 15 year old position that finders don't need to register as a broker in Dominion Resources (available August 24, 1985, overturned March 7, 2000) - this reflects that Division's inclination to broadly interpret when an entity is required to register as a broker. The Committee on Federal Regulation of Securities of the Business Law Section of the ABA urged the SEC to allow non-brokers to establish pre-existing substantive relationships in its August 2, 2000 comment letter on Release 33-7856 (May 4, 2000).

What if a non-broker operates a Web site that establishes substantive relationships with investors online?

The SEC may take enforcement action - since the SEC has warned that it's concerned about non-brokers that operate private offering Web fronts, particularly if investors pre-qualify themselves on a Web form (also known as self-accreditation). See more @ what is self-accreditation.

The SEC has indicated that it would be difficult to demonstrate that a pre-existing substantive relationship exists if a non-broker operates a Web front. The SEC also has stated that it would also be difficult for a company to show that it had a reasonable belief as to a buyer's eligibility if it relies on a non-broker to qualify investors.

Source: The SEC raised these concerns about non-broker service providers in Section II.C.2. and footnote 88 of Release 33-7856 (May 4, 2000). The SEC also asked the Division of Market Regulation to consider whether Web site operators similar to the one in Lamp Technologies I (available May 6, 1997) would be required to register as a broker in footnote 94 of Release 33-7856 (May 4, 2000). The SEC also clarified in footnote 88 of that release how the Lamp Technologies no-action letter (available May 29, 1997) should not be interpreted as allowing non-broker service providers to qualify investors - rather, it should be interpreted solely in the context of private mutual or hedge fund offerings.

Does a company or its broker need to show that it had pre-existing substantive relationships with investors to prove that it did not generally solicit?

Probably not - pre-existing relationships are not the only way to show the absence of a general solicitation. A company or its placement agent also can show that it had a reasonable basis to believe that the offeree was qualified.

A company can show other facts and circumstances - but no one has found an adequate alternative to show the absence of general solicitation yet. The SEC has stated that other alternatives may be possible - but has not suggested what those alternatives may be.

Source: The SEC noted that other methods are possible in footnote 86 in Release 33-7856 (May 4, 2000) and cited footnote 12 in Release 33-6825 (March 15, 1989) as support for its statement.

How can companies or brokers establish substantive relationships with accredited and sophisticated investors online?

With an online suitability questionnaire - so long as a broker reasonably determines whether the investor is eligible (or a non-broker whose procedures have been approved by the SEC staff). See more @ whether a non-broker can operate a Web front.

Online questionnaires have to be "passive" so that it's not considered engaging in general solicitation activities. For example, a broker cannot drive investors to its questionnaire, such as arranging for it to be linked to from other Web sites.

Note that a broker can always demonstrate that an investor was qualified at the time of sale - even if it did not have reasonable grounds for believing that the investor was eligible at the time of qualification.

What information should an online questionnaire elicit from an investor before it can participate in a private offering?

Sufficient information to support a reasonable belief for the broker - as well as to support the beliefs of the companies that hire the broker - that the investor is "accredited" or "sophisticated" (sophistication being relevant if Rule 506 is the safe harbor relied upon).

The SEC staff does not bless whether online questionnaires are properly designed - so it's not entirely clear what type of diligence a broker needs to perform to verify the information provided by investors for it to be considered adequate qualification.

Source: The SEC staff noted that it does not address the appropriateness of online questionnaires in IPONet (available July 26, 1996).

How can brokers solicit a significant number of offerees for a private placement online?

The easiest way is to establish as many pre-existing substantive relationships as possible before a private offering is posted - either by using a Web-based questionnaire or through an e-mail mailing list.

A number of brokers have built databases with thousands of accredited investors that they obtained and qualified through the Web or by e-mail. See more @ service providers for online private offerings.

What are the differences between soliciting investors for a public company's private offering and a private mutual or hedge fund?

From a regulatory standpoint, the point in time when investors are allowed to participate in the offerings.

For a private offering conducted by a public company, an investor may not participate in any private placements that are posted before the investor is deemed qualified by that Web front.

For a private mutual or hedge fund, an investor can participate in private funds that are posted when it was deemed qualified - after a 30 day waiting period - rather than being completely blocked out of these offerings altogether.

The SEC makes a distinction between corporate and fund offerings due to the semi-continuous offering nature of the fund offerings - otherwise, investors would almost never be able to invest online in private fund offerings. The SEC imposes waiting periods on both types of offerings to reduce the likelihood that existing offerings are not used to solicit investors.

Source: These differences are evident by comparing the no-action letters, IPONet (available July 26, 1996) and Lamp Technologies, Inc. (available May 29, 1997).

Can a company or broker accept electronic indications of interest in a private offering?

Yes - so long as the electronic indications of interest meet the conditions in Rule 134. Recently, the SEC staff has strictly construed Rule 134. See more @ SEC's interpretations of Rule 134 in public offerings.

Source: The SEC staff acknowledged in IPONet (available July 26, 1996) that companies can collect electronic indications of interest, as long as they meet the Rule 134(d) requirements.

Should private offering Web fronts register as investment advisers?

No - so long as the Web front doesn't provide investment advice. The Web front should only be a place where investors can find information about pending private offerings.

The Web front should not:

Can a Web front operator be liable as an issuer simply by posting private placement memorandums on its Web site?

Probably not - so long as it merely posts private offering materials and doesn't take a more active role for the companies or offerings listed.

Section 12(1) of the Securities Act of 1933 imposes strict liability for a person that offers or sells unregistered securities without an available exemption. Courts have varied in how they interpret "seller" under Section 12(1), including:

How does Regulation FD affect communications during a private offering?

Companies need to fully comply with Regulation FD while conducting a private offering. Although it was considered, the SEC decided not to exclude communications made by companies during a private offering from the Regulation.

The SEC hinted that if a company needs to share material information during a private offering that has not been made public - that it should protect itself contractually or else be prepared to make the information publicly available simultaneously with the private offer.

Since private offerees are not likely to agree to contractual restrictions - private offering materials should be scrubbed to ensure that they do not contain material information that is not yet publicly available. Since the private offering materials still must disclose sufficient information to meet the antifraud provisions (in other words, there is a duty to disclose in private offerings) - this may require the simultaneous public release of new information by the company as it distributes private placement memorandums.

Source: The SEC discussed how Regulation FD applies during a private offering in Section II.B(6)(b) of Release 33-7881 (August 15, 2000).

What do critics of the SEC's positions regarding online private offerings say?

Most critics believe that general solicitation should be permitted in private offerings - primarily on policy grounds, since it restricts the ability of small businesses to raise capital.

These critics note that communications restrictions are unnecessary since the private offering exemptions require that actual sales be made to qualified investors - they argue that this requirement alone should sufficiently protect investors.

Some critics believe that self-accreditation is appropriate for offerings that typically only attract institutional investors - such as debt and asset-backed offerings.

Some critics believe that investors that are qualified to access password-protected private placement materials should be allowed to invest in offerings already posted when they are qualified - they point out that the time of qualification is irrelevant as to whether an investor is qualified to participate.

Source: The "aircraft carrier" raised the question of whether the general solicitation restrictions should be eliminated and many commentators responded as they have for many years - that it would be beneficial to the market. This issue is discussed in Donald Langevoort, "Angels on the Internet: The Elusive Promise of "Technological Disintermediation" for Unregistered Offerings of Securities" Journal of Small and Emerging Business Law (1998).

The Bond Market Association's June 21, 2000 comment letter on Release 33-7856 (May 4, 2000) asks the SEC to allow self-accreditation for offerings typically sold to institutional investors and criticizes the notion that the timing of qualification is relevant to participation. The Committee on Federal Regulation of Securities of the Business Law Section of the ABA urged the SEC to eliminate prohibitions on general solicitation and allow third-parties to establish pre-existing substantive relationships without registering as a broker or under a new limited broker registration scheme in its August 2, 2000 comment letter on Release 33-7856 (May 4, 2000).

D. State Laws Applicable to Online Private Offerings

Do companies need to comply with state law if they conduct online private offerings under Regulation D?

The same analysis is applied as for off-line private offerings.

Most state securities laws require a Form D to be filed if sales are made in their state - even for offerings that are preempted by federal law from being registered in their state, such as Rule 506 offerings or "covered" securities.

If an offering's state registration regulation is not preempted by federal law, a company must follow the state law in which intends to offer and sell - so it should check the state law for each state in which it intends to offer and sell securities and see what is required - and then register or ensure that an exemption is available in each state. See more @ how online offers are regulated by state regulators.

Many states have limited offering exemptions that piggyback on Regulation D - so that companies entitled to rely on a safe harbor in Regulation D do not have to take further action to comply with a particular state law other than a notice and fee filing.

Source: Cornell Law School has posted most state corporate laws at wwwsecure.law.cornell.edu/statutes.html. Findlaw also has the corporation laws for many states at www.findlaw.com. States are not permitted to regulate the registration of Rule 506 offerings under Section 18(b)(4)(D) of the Securities Act of 1933 (since Rule 506 was promulgated under Section 4(2) of the Act, which is preempted from state regulation in that provision) - but states still can require notice filings and collect fees for Rule 506 offerings as well as prosecute fraud.

How can companies offer securities online only to California residents?

Under California law, a company can use general solicitation by a modified tombstone ad in an exempt offering - so long as all sales are made to "qualified purchasers" in California.

The modified tombstone ad may be posted on a Web site - which can include buttons that lead a viewer to more information about the company and its offering.

The SEC has established an exemption for these California offerings so that they are exempt from the U.S. federal registration requirements - but they still are restricted securities subject to Rule 144 of the Securities Act of 1933 for resale.

Source: Section 25102(n) of the California Corporate Securities Act of 1968 provides this limited offering exemption. The California Commissioner of Corporations has outlined how companies relying on the exemption can conduct Internet offerings in California Commissioner's Opinion 96/2C (October 17, 1996) at www.corp.ca.gov/commiss/op6600.htm. Rule 1001 of Regulation CE exempts a Section 25102(n) offering from the Securities Act of 1933, as adopted in Release 33-7285 (May 1, 1996).

What is a "qualified investor" under the California law that facilitates online private offerings to California residents?

Includes accredited investors - as well as persons (together with a spouse) that either have:

How can companies offer securities online only to New York residents?

Under New York law, a company can offer securities and use general solicitation, including e-mails and information posted on the Web - so long as the securities are offered through a broker who first files a State Notice and Further State Notice (which are simple forms with a filing fee).

Source: These notices are filed with the New York Office of the Securities Commissioner.

How can companies offer securities online only to Texas residents?

Under Texas law, a company can offer securities and use general solicitation without registering the offering with the Texas Securities Board - so long as only investors that essentially are the equivalent of "accredited investors" under Regulation D buy in the offering. See more @ what is an "accredited investor" under Regulation D.

Source: Rule 139.16 is the Texas accredited investor exemption. Rule 139.18 allows brokers to use the Internet to first communicate with investors. An excellent outline (although it may be dated) of Texas securities law written by the Texas Commissioner is at www.ssb.state.tx.us/capaper.html.

Will a state regulate offers made on the Internet if sales are not made in the state?

Most states have followed a NASAA Internet Resolution that encourages state regulators to take appropriate steps to exempt these types of offers if the following two conditions apply:

How do states regulate sales on the Internet?

For the most part, just like an off-line offering - some states have followed a NASAA Internet Resolution that encourages state regulators to take appropriate steps that would allow online sales if one of the following conditions apply:

E. Who is Conducting Online Private Offerings

Which companies have conducted private offerings online?

The following companies have conducted private offerings within the past year:

Which non-brokers are qualifying investors for private offerings online?

Not many - mainly because the SEC and its staff have been reluctant to give assurances as to the circumstances under which it's permissible to operate a Web site that qualifies investors without registering as a broker.

So far, the only non-broker that has received SEC staff relief is Lamp Technologies, which is a private mutual and hedge fund whose participants are limited to "qualified purchasers" and "accredited investors" - and the SEC recently asked its staff to clarify whether that relief would apply in the non-hedge fund context. See more @ whether non-brokers can operate a Web front.

Source: The SEC asked the Division of Market Regulation to consider whether Web site operators similar to the one in Lamp Technologies would be required to register as a broker in footnote 94 of Release 33-7856 (May 4, 2000). The SEC also clarified in footnote 88 of that release how the Lamp Technologies no-action letter (available May 29, 1997) should not be interpreted as allowing non-broker service providers to qualify investors - rather, it should be interpreted solely in the context of private mutual or hedge fund offerings.