SEC Improves E-Capital Raising

New Jersey Law Journal

Volume 191, No. 12

March 24, 2008


BY JONATHAN BICK  Bick is of counsel to WolfBlock of Roseland and is an adjunct professor of Internet law at Pace Law School and Rutgers Law School. He is also the author of 101 Things You Need To Know About Internet Law [Random House 2000] .

The Internet provides private companies with a cost-effective method for introducing themselves to large number of potential investors. It also facilitates efficient capital fund-raising opportunities. The Securities and Exchange Commission's (SEC) revision of Rule 144 make raising capital via the Internet easier and cheaper. The SEC has changed Rule 144 to reduce regulation of restricted securities, thus facilitating Internet capital raising.

The Internet in conjunction with such statutes as the E-sign Act (114 Stat. 464 (2000) - codified at 15 U.S.C. § 7001 et seq.) allows intangible property, including capital stock, to be contracted for and exchanged electronically. However, certain capital fund-raising was not generally available to Internet users due to certain SEC regulations, until recently. In particular, the use of restricted securities to raise capital electronically which are most helpful to cash-poor Internet start-ups because unrestricted securities are less expensive to create than restricted securities, was problematic.

Restricted securities are generally those which are exempt from registration. These securities are not registered and cannot be offered or sold unless they are registered with the SEC or exempt from registration. Rule 144 provides such an exemption and allows investors to resell restricted securities.

While the SEC has allowed companies to issue shares and raise money without registering with the commission, it limits such transactions for most Internet users by imposing certain conditions. More specifically, the SEC must be given notice of such transactions and the imposition of long holding-period requirements. The recent amendment of Rule 144 alleviates these difficulties for Internet users. The Rule 144 change allows a nonpublic issuer to raise capital electronically from private or overseas sources on an expedited basis.

Section 4(1) of the Securities Act exempts transactions from certain SEC regulations by any person other than underwriter. Rule 144 provides a safe harbor from the Section 4(1) restrictions for sales of restricted securities by establishing specific criteria so that security holders will not be deemed to be underwriters of such securities. As a result, sales pursuant to Rule 144 are entitled to the exemption provided by Section 4(1).

Rule 144 used to require a one-year holding period before restricted securities could be sold. The amended Rule 144 reduces the holding period requirement for restricted securities of companies that are subject to the reporting requirements of the Securities Exchange Act of 1934 to six months.

The amendment to Rule 144 appreciably reduces the restrictions on the public resale of securities by the public. After the initial holding period requirement is met, those who have not been affiliated with the security seller during the prior three months, will not be subject to the Rule 144 conditions relating to volume limitations, manner of sale requirements, and filing Form 144.

Internet capital fund-raisers must contend with the implementation of each regulation to all jurisdictions due to the nature of the Internet, where as traditional capital fund-raisers need only contend with the application of regulations in the jurisdiction in which funds are raised. The reduction or elimination of capital fund-raising regulations favors the Internet capital fund-raiser.

Thus, the Rule 144 elimination of certain regulations, levels the playing field for Internet capital fund-raisers with respect to traditional capital fund-raisers by reducing the regulation implementation costs.

The Securities Acts of 1933 and of 1934 necessitate information filing at the time a security is issued and require the periodic dissemination of information regarding these securities. The objective of the 1933 and 1934 Acts is to protect American investors by giving them timely and accurate information.

Traditionally, an Initial Public Offering (IPO) is used by firms to raise capital. Section 5 of the 1933 Act requires persons offering securities for sale within the jurisdiction of the United States to comply with the Act's registration requirements to Internet based IPOs. The anti-fraud provisions of the 1934 Act have been interpreted to extend subject matter jurisdiction to transactions taking place outside the United States when substantial fraud is found to have occurred in the United States.

The conventional IPO generally requires a bank to underwrite the transaction and attract buyers. For these services, investment banks charge a fee, starting from six to 10 percent and going as high as 40 percent, of the expected offering. The Internet, however, provides a less costly alternative for attracting the attention of a large number of potential investors. Thus, the new SEC rule reduces the cost to raise capital by eliminating the discount from market prices giving to the underwriter.

In particular, the amendment particularly should benefit Internet firms, which often sell securities in private placements. A shorter holding period should lower the illiquidity discount noted above and given by companies raising capital in private placements and increase the usefulness of the Rule 144 safe harbor.

Restricted securities are securities acquired in unregistered, private sales from the issuer or from an affiliate of the issuer. Internet firm investors typically receive restricted securities through private placement offerings, as compensation for professional services, or in exchange for providing 'seed money' or start-up capital to the company.

To protect the public from fraud the SEC limits the resale of stock that is not registered. The most common exemption to the limitation on resale rule is Rule 144. Rule 144, promulgated under the Securities Act of 1933, is a safe harbor provision that allows holders of restricted securities to make sales of stock when certain conditions are met. Rule 144 provides a 'safe harbor' exemption to sellers for selling restricted or control securities.

Rule 144 protects the public by barring the creation of public markets in securities of issuers concerning which adequate current information is not available to the public. Where adequate current information concerning the issuer is available to the public, the rule permits the public sale in ordinary trading transactions of limited amounts of securities owned by persons controlling, controlled by or under common control with the issuer and by persons who have acquired restricted securities of the issuer.

The amendments to Rule 144 provide for a reduced holding period, the elimination of Form 144 and the application of the Rule 144 safe harbor to larger transactions. The holding period for non-affiliates holding securities in a reporting company was reduced from one year to six months and non-affiliates need no longer prepare and file Form 144 when making sales of restricted securities under Rule 144.

Prior to the amendment Rule 144, when a person place an order for a restricted stock, a notice to the SEC on Form 144 was required if the sale involved more than 500 shares or the aggregate dollar amount was greater than $10,000 in any three-month period. In addition, prior to the amendment Rule 144, the sale must take place within three months of filing the 144 Form and, if the securities have not been sold, the seller must file an amended notice. Removal of the notice requirement streamlines Internet capital fund-raising.

Despite these changes, the 'current public information' requirement remains in place under the amended rules. Furthermore, most of Rule 144's requirements still apply to affiliates, although affiliates do benefit from the reduced holding period, and the thresholds for the filing of Rule 144 were raised to $50,000/5,000 share limit.